One of the challenges in commercial real estate development is speed. Well-located parcels or repositioning opportunities often require a decision within days or weeks, leaving little time for a detailed underwriting model.
In these situations, developers rely on simple metrics to determine whether a project is even worth pursuing. One of the most common is the development spread, which helps investors compare the relative risk and reward of developing a property versus acquiring a stabilized asset with in-place cash flow.
What is the Development Spread?
The development spread is a quick calculation used to size the potential profitability—and relative risk—of a development or major value-add project. It is defined as:
Development Spread = Going-In Cap Rate – Going-Out Cap Rate
The logic is straightforward. If an investor can buy a stabilized property with predictable income, taking on development risk should offer a meaningfully higher return. The development spread helps quantify whether that premium exists.
Going-in Cap Rate
The going-in cap rate — also referred to as development yield or yield on cost — is calculated as a project’s stabilized net operating income (NOI) divided by total project cost. In a development, total cost includes land acquisition, hard costs, soft costs, and financing-related expenses.
Going-out Cap Rate
The going-out cap rate (also called the exit or terminal cap rate) is the stabilized NOI divided by the estimated market value at sale. Because the sale may occur years in the future, this figure is based on comparable sales, market conditions, and investor expectations at stabilization.
Cap rates themselves are influenced by factors such as property type, asset quality, market fundamentals, interest rates, and perceived risk.
Development Spread Example
Suppose a developer is evaluating a multifamily development in New York with a total project cost of $5,000,000, including land.
Based on the pro forma, stabilized NOI is projected at $500,000, implying a going-in cap rate of 10% ($500,000 ÷ $5,000,000).
After reviewing comparable sales and speaking with local brokers and lenders, the developer estimates a stabilized market value of $6,125,000. Using the same NOI, the going-out cap rate is 8.16% ($500,000 ÷ $6,125,000).
The development spread is therefore:
10.00% – 8.16% = 1.84% (184 basis points)
This spread represents the incremental return the developer expects to earn for taking on construction, leasing, and market risk.
Development Spread and Profit Margin
The same inputs can be used to estimate a project’s potential profit margin:
Profit Margin = (Going-In Cap Rate ÷ Going-Out Cap Rate) – 1
Using the example above:
10.0% ÷ 8.16% = 1.22
1.22 – 1 = 22% profit margin
Applied to a $5,000,000 project, this implies a potential profit of approximately $1.13 million.
On its own, this figure has limited meaning. Its value comes from comparison—specifically, whether this return justifies the added risk relative to purchasing a stabilized multifamily asset with similar expected returns.
What is a Good Development Spread?
There is no universally “correct” development spread. Acceptable spreads vary by property type, market, asset quality, and investor experience.
That said, a commonly cited rule of thumb is that a development spread of at least 1.5% is generally considered attractive. Lower spreads may suggest that the risk of development is not being adequately compensated, while larger spreads often indicate higher perceived risk by the market.
Importantly, a wider spread does not guarantee a better outcome—it simply reflects higher uncertainty around execution, leasing, and exit assumptions.
Limitations of the Development Spread
The development spread is intentionally simple, which creates several limitations:
- It does not account for the cost of capital. A project with a 10% margin may be unattractive if financing costs exceed that level.
- It assumes stable market conditions and does not model cap rate expansion or compression.
- It ignores timing of cash flows, lease-up risk, and operating variability during the hold period.
For these reasons, the development spread should be used as a filtering tool, not a final decision-maker. Projects that pass this initial screen warrant deeper analysis; those that do not can often be eliminated quickly, saving time and resources.
Development Spread – Next Steps
If a development spread suggests that a project may be viable, the next step is a more detailed underwriting process. This typically involves a discounted cash flow (DCF) analysis that models annual or monthly cash flows and calculates metrics such as Internal Rate of Return (IRR), Net Present Value (NPV), and Equity Multiple.
DCF analysis allows investors to stress-test assumptions, refine budgets, and evaluate downside scenarios—something the development spread cannot do on its own.
