Like any investment, an allocation of capital to a commercial property, specifically a shopping center, involves risk—but risk can be a tricky thing to measure or quantify. In a commercial real estate investment, it is often considered on a relative basis. From this standpoint, measuring risk can be done using the “development spread.”
What is the Development Spread?
In a ground-up development or major value-add project, the development spread is a back-of-the-envelope calculation used to assess whether or not the project is worth the relative risk it entails. It is calculated as the “Going In Cap Rate” minus the “Going Out Cap Rate.” It can be helpful to understand how these components are calculated.
A property’s going-in cap rate—sometimes called the yield on cost or return on cost—is the property’s cap rate at the time of purchase. It is calculated as the property’s stabilized Net Operating Income (NOI) divided by the total cost. Regarding the total cost, this is the total project cost in a development, or it could be the purchase price plus the renovation cost in a value-add project. So, for example, if stabilized NOI is equal to $100,000 and the total cost is $1,000,000, the going-in cap rate is 10%.
The going-out cap rate in real estate—sometimes called the “sell to cap rate”—is the cap rate at the time of sale. It is calculated as a property’s stabilized NOI in the year of the sale divided by the projected sales price. In many cases, a sale may not occur until 5 to 10 years into the future, so it is necessary to estimate the numbers. Assume the same property had stabilized NOI in year 10 of $160,000, and a projected sales price of $2.13M. This is equal to a going-out cap rate of 7.5%.
So, the difference between the going in cap rate of 10% and the going out cap rate of 7.5% is 2.5%, and this is the development spread. But, what does it mean?
What is a Good Development Spread for a Commercial Real Estate (CRE) Asset?
Naturally, this type of calculation begs the question, what is a good development spread? Like many things in real estate, there is no hard and fast answer, and there are many variables involved.
For example, certain properties, such as office buildings, tend to carry more risk, while other properties, such as multifamily, tend to be considered less risky. Class A assets—the newest and the most luxurious—tend to sell for a higher amount per square foot than Class B or C. Properties with high occupancy tend to sell for more than those with low occupancy. In general, properties with less risk tend to sell for lower cap rates while those with more risk tend to sell for higher rates. The point is, there are a lot of variables that go into the answer, but a general rule of thumb is that a spread of 1.5% or higher is desirable.
How the Development Spread Helps Investors Understand Risk
Like all investments, there is a strong correlation between risk and return. The amount of perceived risk associated with a property is connected to the potential return that can be gained from investing in it. These factors are determined by the “market” and are reflected in the property’s cap rate—and thus, the development spread. The larger the development spread, the riskier the project. The smaller the development spread, the lower the risk.
For example, a project with a potential development spread of 5% would seem to be very appealing as it could prove to be incredibly profitable. However, a development spread of 5% also means that the market perceives the real estate development or renovation to have more risk than a project with a 2% or even 3% spread. As such, there is a higher chance that things will not go according to plan and that the actual return can vary greatly from the original estimate.
Development Spread Example
Suppose that a real estate investor is trying to decide between two properties. One is a mixed-use space located outside of New York City. It is fully occupied, and the tenants include established retailers and some apartment units. The property is cash flow positive. Per the pro forma, it produces a stabilized Net Operating Income of $200,000 and has a purchase price of $2.85M, which means the going-in capitalization rate is 7%. After a 10-year holding period, the projected NOI is $270,000, and the projected sales price is $4.15M, which implies a going-out cap rate of 6.5%. The spread is 0.5% for the stabilized property.
The other property contains retail space only. It is located outside of Atlanta, and is a little bit run down. It has a high level of vacancy, and the existing tenants are on short-term leases. There is little-to-no leasing activity, and the operational metrics indicate that the property is losing money each month. The property also has a potential stabilized NOI of $200,000, but the purchase price is $1.6M. As part of the business plan, the investor plans to invest $500,000 in repairs and renovations bringing the total cost to $2.1M. As such, the going-in cap rate is ($200,000 / $2.1M) 9.5%. After a 10-year holding period, the projected NOI for the retail building is also $270,000 and the projected sales price is also $4.15M. This makes the going out cap rate 6.5% and the development spread 3%.
So, for this investor, the key question is this: Is the risk of a major renovation and lease-up worth the incremental 2.5% development spread? The answer will be different for everyone. Perhaps an experienced investor will not see this as an issue, whereas a new investor may not be comfortable with the risk of managing a major redevelopment project.
Development Spread and Profitability
The inputs needed to calculate the development spread can also be used to make a back-of-the-envelope calculation of an investment opportunity’s profitability. The calculation is the going-in cap rate divided by the going-out cap rate, minus 1.
Using the retail example above, the going in cap rate is 9.5% and the going out cap rate is 6.5%. Thus, an investor could expect a profit margin of ((9.5% / 6.5%) – 1) 46.15%. For many investors, this is an easier way to think about potential profitability.
What is a good profit margin? Again, it depends on the investor, the property type, the real estate market, and submarket. For one investor, a 30% profit margin may be fine, but others may look for a 45% margin.
Development Spread vs. Discounted Cash Flow Analysis
While the development spread can provide some very useful information, it should not be relied upon as a complete analysis of the property’s cash flow. It is a back-of-the-envelope calculation meant to be made quickly to help investors and lenders size up an investment opportunity.
For a complete, detailed analysis of property’s cash flows and potential valuation, the standard is a completed discounted cash flow analysis or “DCF.” This takes longer and requires additional information about a property’s income, operating expenses, and loan pricing. It should be completed after the development spread analysis has concluded that the project is worthwhile.
Conclusions and Summary
The development spread is a back-of-the-envelope calculation that can be used to determine whether or not a project or investment is worth the risk of development or renovation. The required inputs are a property’s stabilized cash flow and valuation projections.
There is no “right” development spread, but there is one that an investor perceives as being worth the risk. As a general rule of thumb, it should be at least 1.5%.
Interested In Learning More?
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If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
