One of the unique challenges faced by commercial real estate (CRE) developers is that they often have to make important financial decisions quickly and with relatively little information. For example, if a developer finds a well-located parcel of land, it is likely that they will have make a purchase decision within days or weeks and without the time to do a detailed financial analysis of their potential real estate investment.
One of the ways they can do this is to complete a quick, back-of-the-envelope calculation known as the “development spread.”
What is the Development Spread?
The development spread is a quick and easy calculation that developers use to size the potential profit/financial feasibility in a transaction. Mathematically, the development spread is the difference between a project’s going-in capitalization rate and going-out or sales cap rate. To fully understand this formula, it is helpful to break it into its components.
The going-in cap rate is simply the project’s estimated net operating income (NOI) at stabilization, divided by the project’s initial cost. On occasion, it may also be referred to as the “yield on cost” or development yield.
The going-out cap rate is the project’s NOI at stabilization divided by the estimated market value once construction is complete. On occasion, it may also be referred to as the exit cap rate or terminal cap rate.
It should be noted that cap rates in real estate can be affected by a variety of factors such as property type, forecasts for economic growth, perceived risk, asset class, and movements in the interest rate for the 10-year treasury.
The difference between these two values allows a developer to compare the yield or total return that he or she could earn from taking the risk of developing a property from the ground up, versus buying an existing property with in-place cash flow. To illustrate how this works, an example is helpful.
Development Spread – An Example
Suppose that a real estate investor/developer is evaluating the potential purchase of a parcel of land in New York, and the development of a commercial multifamily property on it. They have an estimated development budget of $5,000,000 (which includes the cost of the land).
Based on their proforma projection, they believe that they can achieve a stabilized Net Operating Income of $500,000 once construction is complete and the units are fully leased up. In such a case, the going-in cap rate would be 10% ($500,000 / $5,000,000).
The market value of the property can be difficult to estimate prior to development of it, but reviewing the recent sales of comparable properties can provide per unit and per square foot metrics that are useful. Continuing the example, suppose that the developer has reviewed comparable sales and spoken with local lenders and brokers, and has good reason to believe that the property will have a market valuation of $6,125,000. Given projected, stabilized NOI of $500,000, the going-out cap rate is estimated to be 8.16% ($500,000 / $6,125,000).
So, the difference between the going-in cap rate of 10% and the terminal cap rate of 8.16% is 1.84% or 184 basis points (bps).
Development Spread and Profit Margin
With the development spread known, the developer can take one additional step by calculating the potential profit margin and profit on the deal.
The profit margin is calculated by dividing the going-in cap rate by the going-out cap rate and then subtracting 1. Using the example above, the going-in cap rate of 10% can be divided by the going-out cap rate of 8.16% to obtain a result of 1.22. Subtracting 1 suggests a profit margin of 22%.
Finally, the profit margin of 22% can be multiplied by the total estimated project cost of $5,000,000 to get a potential dollar profit of $1.127M.
Out of context, these numbers may not make sense on their own. But, these results can be compared to the return and profit that could be earned from purchasing an existing multifamily property to assess whether the developer is being compensated for the risk of building the project from scratch. If the developer makes the comparison and the results are similar, there is no incentive to build—he or she could just buy.
Development Spread – Next Steps
If, upon completion of the development spread estimate, it is determined that the project makes sense, the investor can move on to a more detailed cash flow analysis. The standard for this is an underwriting technique called “discounted cash flow” or simply “DCF.” In this analysis, the developer would have an opportunity to refine the budget and create a more detailed proforma of monthly or annual cash flows. From this, more detailed rate of return calculations can be completed including: Internal Rate of Return (IRR), Net Present Value (NPV), and Equity Multiple.
Limitations of the Development Spread
The development spread is meant to be a back-of-the-envelope calculation, not a full-blown financial analysis. To that end, there are a few limitations that investors should be aware of:
- Does not take into account cost of capital and/or interest rates. A profit margin could be 10%, but if the cost of capital is 12%, this is not a feasible project.
- Does not take into account market volatility or potential cap rate compression/expansion.
- Does not account for changes in leasing activity or lease terms over the course of the investment holding period.
For these reasons, the development spread should not be solely relied upon to make a commercial property investment decision. Instead it should be used as a way to filter through potential opportunities and to quickly eliminate the ones that don’t make financial sense. For those that show promise, a full discounted cash flow analysis should be completed prior to making a buy/don’t buy decision.
Interested In Learning More?
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To learn more about our real estate investing opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.