The development spread is a back of the envelope calculation that is commonly used by real estate developers. It is a quick and easy way to assess the financial viability of a real estate development project before undertaking a more in-depth analysis. In this article, we’ll take a closer look at the development spread and show an example of how it’s used in practice.
What is the developmental spread?
First of all, what is the developmental spread? Spread the development is defined as the difference between the entry rate and the exit rate.
The boarding fee is the projected stabilized net operating income for the property divided by the initial project costs.
For example, suppose that after the construction and rental of a project, the stabilized net operating income is $100,000 and the total project costs are $1,000,000. That means the entry rate would be 100,000/1,000,000 or 10%. It is also common to think of the entry-level rate as the return on cost, development return, return on cost, cost cap rate, or build-to rate.
The curfew rate is the expected stabilized net operating income for the property, divided by the market value on delivery.
For example, suppose the stabilized net operating income for our project is again $100,000 and the projected market value of our project once stabilized is $1,200,000. In this case, the going out rate would be 100,000/1,200,000 or 8.33%. It is also common to see the outgoing cap rate, the exit cap rate, terminal cap rate, market cap rate or the “sell-to” rate. This maximum outward rate can be calculated by examining the prevailing maximum rates for comparable properties in the same submarket.
The development spread is the difference between the entry rate and the outgoing rate. In the example above, the development spread would be 10% – 8.33% or 1.67%
The development spread is a quick way to compare the return on developing a new project with the return on acquiring a comparable but already existing and stabilized property. The development spread tells you how much more return you will get by choosing to build a new project and as such take on all the additional risks of development. Typically, real estate developers aim for a development spread of 150-250 basis points.
Practical example of spreading development
Let’s look at an example of how development spread can be used in practice. Suppose we are evaluating a potential project for the development of an office building. Our estimated development budget shows a total project cost of $2,500,000.
Once the project is built and leased, we expect a stabilized net operating income of $250,000. So our initial cost is $2,500,000 and our projected stabilized net operating income is $250,000. That means our entry rate is 250,000/2,500,000 or 10%.
To estimate our nightlife rate, we can research recently sold comparable properties in the local market. Based on our own internal market data and discussions with local lenders, investors, appraisers and brokers, we believe the market cap for our completed and stabilized project is 8%.
So our entry rate is 10% and our exit rate is 8%. If we subtract the capital outflow cap from the inflow cap, we get our development spread of 2%.
In practice, you can also hear this scenario as “build to a 10-cap” and “sell to an 8-cap”. Often, real estate developers use this “build to” and “sell to” language to describe the development spread.
Development spread and profit margin
The entry rate and the exit limit rate can also be used to calculate a backward profit margin. In combination with the development spread, the profit margin can provide some additional context about the financial viability of a project. Let’s see how we can quickly calculate the profit margin, using the same numbers from the development spread.
To calculate the profit margin, you can simply divide the entry limit by the outgoing cap price and then subtract 1 from that. This is the same as dividing the market value by the total cost and subtracting 1. Here’s the formula:
So in our example above this would be (0.10 / 0.08) – 1 or 25%. This is like taking our stabilized market value of $3,125,000 ($250,000 NOI divided by 8% market cap), divided by our total development costs of $2,500,000, and 1. If we do this, we get (3,125. 000/2,500,000) – 1 , or 25%. This means that our total profit amount is $2,500,000 (our project costs) x 25% (our profit margin) or $625,000.
Using these calculations on the back of the envelope in our example above, we were able to quickly see that the development spread on our project is 2%, meaning we will earn another 2% above market cap. This also translates into a 25% profit margin, which would be $625,000 based on our estimated project cost.
These are, of course, simplified calculations and do not take into account timelines, selling costs, closing costs, leverage, unexpected cost variations or delays, etc. Nevertheless, these are quick and easy “back-end” calculations that allow you to identify potential projects with minimal effort.
Development Spread vs. Discounted Cash Flow Analysis
If a project doesn’t make sense using simple backwards like the development spread and profit margin, then it’s highly unlikely that it makes sense to use a more detailed discounted cash flow analysis. However, if a project looks financially viable based on development spread and profit margin, then refining the development budget and creating a more detailed pro forma is usually the next step. A detailed monthly or annual proforma can then be used to calculate an internal rate of return, net present value, modified internal rate of return, multiple of equity and other financial metrics.
It allows you to sharpen your pencil and take into account all the revenue, costs, timing, as well as the best and worst scenarios. Our Proforma software is designed to help you create a detailed proforma for commercial real estate projects, and includes functionality for complicated lease structures, unit mixes, custom fees, variable and fixed costs, development costs, capital expenditures, permanent and interest-only construction loans, and more .
In this article we discussed the development spread in real estate. We defined the development spread as the difference between the entry limit and the outgoing cap rate. This difference is the extra return earned from running a development project and all the associated risks. We then showed how the same inbound and outbound cap rate can be used to calculate the profit margin for a development project. In combination with the development spread, the profit margin provides additional context about the financial viability of a real estate development project.
Finally, we compared these back-of-the-envelope calculations with a more sophisticated pro forma and discounted cash flow analysis. While a more detailed pro forma and discounted cash flow analysis is an important next step after a project has passed an initial screen, it is unlikely that a project will make sense using a discounted cash flow analysis if it does not already make sense to to use the development proceeds. and profit margin calculations.