Development spread is a quick and straightforward calculation that developers use to assess a real estate development project’s potential profitability or financial feasibility before finalizing the analysis. Mathematically, the development spread is defined as the difference between the going-in cap rate and the going-out cap rate.
The going-in cap rate is simply the projected net operating income (NOI) at stabilization, divided by the project’s initial cost. This term can sometimes be referred to as “yield on cost” or “development yield.” The going-out cap rate is the NOI of the project at stabilization divided by the estimated market value after construction is completed. It can sometimes be referred to as the exit cap rate or the final cap rate. It is worth bearing in mind that cap rates can be affected by various factors, such as type of property, growth expectations, asset class, perceived risk and movements in 10-year treasury interest rates. The difference between these two values allows the developer to compare the total return or yield achieved by taking the risk of developing a property from scratch versus buying an existing property with cash flow in place.
As with most investments, developers rely on spreads to determine the potential return from the investment. Developers typically look for a spread of 150-200 basis development points. To calculate the development spread, you will find the difference between the going-in cap rate and the going-out cap rate and multiply it by 10,000.
Let’s take a look at an example of how the development spread can be used in practice. Suppose we are calculating a conceivable development project for an administrative building, and our estimated development budget shows a total project cost of $2,500,000. Once the project is constructed, we look forward to a stabilized net operating income of $250,000. Hence, our initial cost is $2,500,000, and our stabilized net operating income is $250,000. This is to say that our preliminary cap rate is 250,000/2,500,000 or 10%.
We could also look for comparable properties recently sold in the local market to estimate the going-out rate. Based on our internal market data and discussions with local creditors, investors, appraisers, and stockbrokers, we believe the market cap rate of our concluded and stabilized project is 8%. Thus, our going-in rate is 10%, and our going-out rate, 8%. If we subtract the going-out cap rate from the going-in cap rate, we obtain our expansion spread of 2%. In practice, you may also get to know about this scenario called “building to a 10 cap” and “selling to an 8 cap”. Real estate developers often use this “build to” and “sell to” language to describe the development spread.
So far, we discussed the development spread in the real estate market. We also defined the development spread as the difference between the going-in cap and the going-out cap and have concluded that this is an opportunity to be seized. On this note, a developer will run an expected development cost, consider the development timeline, and then perform a discounted cash flow analysis to examine the opportunity further. This is a mandatory concept of commercial real estate.
