Development Spread

All,

For some reason I'm conceptually challenged by the concept of development spread - ie. yield on cost of 7% vs. exit cap of 5% = development spread of 2%. What does that number actually mean and what does it signify?

Can this concept also be applied to acquisitions and not only ground up dev?

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Comments (9)

Apr 12, 2021 - 8:14pm

Yield on cost would be NOI/cost
So if NOI is 700k and Cost is 10Mill it would be 7% YOC(Yield on Cost)
Exit Cap would be Cap rate at Sale so a 700NOI/(.05 Exit Cap)= 14Mil Sale Price

This is applied to development deals that shows what the sale price would be calculated as part of the cash flows to get the return metrics for the dev deal (IRR, MOIC, NPV, etc) but showing a spread for an acquisition deal from time of acquisition to disposition is very common as well on a 5 or 10 year timeline 

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Apr 12, 2021 - 8:29pm

Conceptually, (1) you are creating (i.e., developing) a series of cash flows with a 7.0% yield on the amount of money required for you to create those cash flows, and (2) third parties are willing to acquire that series of cash flows (that you took on the risk of creating) for a price that would imply a 5.0% yield. Keeping the cash flows the same, then the only thing that changed is the denominator of the yield calculation.

$5 NOI / $71 development cost = 7% YoC.

$5 NOI / 5.0% cap rate = $100 purchase price

$100 - $71 = $29 unlevered development profit.

Obviously, the thinner the spread, the less profitable the development would be (assuming a merchant build model of course). The magnitude of that spread, and wether the developer believes the spread represents fair compensation (i.e., projected profits) to take on the risk of the development venture is part of what it means for a deal to "pencil" or "not pencil". Obviously, a developer would think about basis as well to govern their assumptions. 

Yes, yield-on-cost is used in acquisitions all the time, usually for all value-add deals or hotel acquisitions requiring an upfront pip upon sale/change-of-control, etc.

Jun 9, 2021 - 3:48pm

This is directionally and largely correct, but is missing a few important distinctions.

At a high level, the development spread reflects the development margin, as illustrated above.  However, not only is the magnitude of the spread important, but the starting and ending point.  To clarify, let's use two examples:

Example 1

You develop a project for 100 with a NOI of 10 (or a 10.0% development yield) and a stabilized yield (or spot cap rate) of 6.5%, thus 350 bps of spread.  This represents a 54% development margin, which is best calculated as the development yield / the stabilized yield - 1.

Example 2

You develop a project for 100 with a NOI of 4 (or a 4.0% development yield) and a stabilized yield (or sport cap rate) of 2.5%, thus 150 bps of spread.  This represents a 60% development margin, which is best calculated as the development yield / the stabilized yield - 1.

The point I am adding is that the stabilized yield is just as important as the development spread in that is is part of the equation to reflect value creation, or alpha, of the project.  Hence, a project in a CBD submarket may take much longer to develop, but is still compelling, because of the value creation.

Jun 10, 2021 - 11:39am

Great point, I think something most people miss at first is that the spread on it's own is a fairly useless metric, it needs to be taken in context. Development yield and cap rate are important factors, as is the type of asset under consideration.

With a development yield of 7% and cap rate of 5% (i.e. 2% spread), I get a 40% development margin. Essentially this is saying if my project cost is $100M, I'm creating $40M of value ($140M stabilized value) - if I wanted to buy instead of build, I would have to spend $40M more unlevered to get a similar property.

The question a developer then asks is this - is the margin significant enough to merit the risk of undertaking the development. For a given spread in a given context, the answer might be very different if we're talking about building apartments vs. a build-to-suit for a single credit tenant.

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Apr 12, 2021 - 9:15pm

This may not be nuanced but say you develop at a Yield on Cost of 10% and then you sell at a 5 cap, you just doubled your money.

Said another way, you put $100m into a project, the NOI is $10m a year. You then sell go to market and it's valued at a 5% cap rate.  You can sell the property for $200m, or a 100% gain.

Apr 13, 2021 - 9:41am

For me, it's two-fold: (1) it's your "profit" in the deal, although to what extent your profit actually is on a deal is dependent on a number of factors including debt, timing, etc. and (2) it's your risk cushion - all things being equal, a deal that is built for a 50bps spread (6.5% ROC and a 6.0% assumed exit cap rate) is riskier than a deal with 100bps of spread. Your spread allows you to absorb things like cost overruns, drop in market rents, increase in opex, and most importantly increase in the cap rate. The risk component also explains why someone will need more spread to develop a hotel than they will for a build-to-suit development for a credit tenant. The former you may want 200+bps of spread, the latter some people are willing to build for 25-50bps. 

Apr 13, 2021 - 12:53pm

The simple answer is that it helps solve the question: Is this development economically feasible? If you are building a development at the same cost as existing product (5% YOC, 5% cap), there would be no reason to develop. You would just buy an existing building and forgo the cost, risk and pain of going through the development process.

The larger the development spread, the more "value" is being generated by development.

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