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Exit Cap could essentially be called the exit yield.
So when you take the Exit Cap minus the YoC it is really a rough calculation on how profitable the deal MIGHT be. So if you build it to a 7 and you know the market cap is a 6; you are estimating a 100 bps spread.
Also, the YoC is basically a direct cap using the Yr1 or 2 NOI divided by the project budget. The Exit Cap is taking your terminal year NOI divided by your estimated market value at the end of your hold.
It is just a way to pencil out the amount of value you can get from a development on the back of an envelope. I have never used the spread number itself to calculate anything though, I consider it more of a yard stick to measure a deal at a macro level.
Would you say Yield on cost is a better metric compared to cap rate when it comes to calculating the return on an investment? As the cap rate does not take into account that NOI could fluctuate if it is not stabilized and also does not take into account that the property could need rehab expenses after acquiring the property. The reason I see yoc as more truthful is that takes into account total acquisition cost, not just sales price and also stabilized NOI. Than you!
Edit: Temporary insanity
Makes sense. Yea I don’t think anyone fully relies on that spread but I’m always curious how highly thats regarded out there.
It doesn’t make a ton of sense to me because I’ve run pro formas on different development deals and when you get pretty granular you would think your EM gives you a good idea of net dollars to be made, and that number, at least for me, has never matched what the spread shows.
Typically, developers would like to see a Yield-to-Cost vs Exit Cap spread of 150 basis points (or more). However, one thing that isn't often mention level of the YTC or Exit Cap on a stand alone basis.
Consider these scenarios:
Scenario 1 - "Develop to a 200 basis point spread" - Develop a $1,000,000 Building with a 8% Yield-to-Cost (80,000% NOI) and a 6% Exit. This nets a 1.33x multiple (if we exclude interim cash flow during hold).
Scenario 2 - "Develop to a 100 basis point spread" - Develop a $1,000,000 Building with a 4% Yield-to-Cost (40,000% NOI) and a 3% Exit. This nets a 1.33x multiple (if we exclude interim cash flow during hold).
In A+ Core Markets (mainly SF or NYC), I'll talk to potential JV partners from secondary markets who are scared off due to the yield-to-cost vs exit spread being "too tight", while not considering the math example above.
tl;dr - While Yield-to-exit spread is useful and allows a developer an easy back-of-the-envelope calculation to help determine if they should dig in further, the magnitude of the spread is not the end-all-be-all as some make it seem.
It's a metric that is useful to all developers but particularly useful to "merchant builders", whose bread and butter is to build a building and immediately flip it as a stabilized property to a core investor.
The reason it is "so important" is because it's the easiest way to calculate the sales price versus the cost-to-build and it allows a developer to know (within 5 seconds) how much money they stand to make on a development.
An easy way to think about it is, (Yield-to-Cost minus Exit) divided by Exit. This will give you your unlevered deal multiple.
For example, a 5% YTC and a 3% Exit would be (5 minus 3) divided by 3, which is a 1.66x multiple.
Nice addition, never thought about it like that. I guess developers should look more in terms of % differential in YOC and exit cap instead of simply a bps spread.
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