The development spread is a fundamental concept in real estate that offers developers a quick method to assess the financial viability of a project before diving into extensive analyses. This article provides insights into what the development spread is, how to calculate it, and its significant implications in evaluating real estate investments.
What is the Development Spread?
The development spread refers to the difference between the going-in cap rate and the going-out cap rate. Understanding these terms is crucial for any real estate developer or investor.
Going-In Cap Rate
The going-in cap rate is calculated by dividing the projected stabilized net operating income (NOI) of the property by its initial project cost. For instance, if a project anticipates a stabilized NOI of $100,000 and the total cost is $1,000,000, the going-in cap rate would be:
Going-In Cap Rate = Stabilized NOI / Total Project Cost
Going-In Cap Rate = 100,000 / 1,000,000 = 10%
This metric may also be referred to as yield on cost, return on cost, or cost cap rate.
Going-Out Cap Rate
The going-out cap rate similarly divides the projected stabilized NOI by the market value once the project is completed. Continuing with our example, if the expected market value post-stabilization is $1,200,000, the going-out cap rate can be calculated as:
Going-Out Cap Rate = Stabilized NOI / Market Value
Going-Out Cap Rate = 100,000 / 1,200,000 = 8.33%
Like the going-in cap rate, the going-out cap rate is often referred to as the exit cap rate or market cap rate.
Calculating the Development Spread
The development spread quantifies how much additional return a developer can expect from new construction versus acquiring a similarly stabilized property. It is simply the difference between the going-in and going-out cap rates.
Development Spread = Going-In Cap Rate – Going-Out Cap Rate
Using our prior calculations: Development Spread = 10% – 8.33% = 1.67%
Typically, developers target a development spread ranging from 150 to 250 basis points.
Practical Application of Development Spread
To illustrate its practical application, let’s consider an office building development project with a total estimated cost of $2,500,000 and a projected stabilized NOI of $250,000. The relevant calculations are:
Going-In Cap Rate = 250,000 / 2,500,000 = 10%
Now, if the internal market analysis suggests a going-out cap rate of 8%, the development spread would consequently be:
Development Spread = 10% – 8% = 2%
This scenario can also be articulated as “building to a 10 cap” and “selling to an 8 cap” among industry professionals.
Profit Calculation Using Development Spread
The relationship between cap rates and the development spread allows for a quick profit estimate, enhancing the understanding of a project’s financial viability. In our example, this involves calculating the cost markup:
Cost Markup = (Going-In Cap Rate / Going-Out Cap Rate) – 1
Cost Markup = (0.10 / 0.08) – 1 = 25%
This profit estimate aligns with calculating the market value derived from NOI and cap rate:
Market Value = NOI / Going-Out Cap Rate = 250,000 / 0.08 = $3,125,000
Further computations show a total profit of:
Total Profit = Project Cost x Cost Markup = 2,500,000 x 25% = $625,000
This results in a profit margin of:
Profit Margin = 625,000 / 3,125,000 = 20%
Development Spread vs Discounted Cash Flow Analysis
If a project fails to meet initial criteria based on the development spread, it is likely that a more complex discounted cash flow analysis will not validate it either. Conversely, if the project seems viable using the development spread and profit margin metrics, producing a detailed pro forma becomes the next logical step.
A detailed pro forma would incorporate factors such as various income streams and costs, enabling developers to analyze scenarios thoroughly and compute metrics like internal rate of return or net present value.
Conclusion
This article provided an overview of the development spread’s significance in real estate. We discussed its definition, calculating methodology, and application in assessing a project’s financial feasibility. The metrics also lay the groundwork for more detailed analyses that can further elucidate a project’s profitability and risks. Understanding the development spread is an essential skill for successful real estate development.
