Real estate developers often use a cap rate spread analysis to measure the potential profitability of a real estate development. It’s a back of the envelope approach to recognize whether a project is worth pursuing, without performing a sophisticated discounted cash flow analysis. This is done by using two different cap rates. The first cap rate is a reflection of the cost of building the property. The second cap rate is the cap rate that the property will sell for upon completion.
The going in cap rate is also called the “yield-on-cost” or return on cost. When I learned this concept, it was more intuitive to think about this concept in terms of a going-in rate and a going-out rate. For that reason, I’ll used the term going-in cap rate. Another way of thinking about this concept is to recognize that you are building to a cap rate and selling to a cap rate. The difference between the going-in cap rate and the going-out cap rate is the development spread. The going-in cap rate is calculated by the below formula:
The going-out cap rate is more intuitive for those with an understanding of cap rates. The going-out cap rate is what we typically think of when discussing a cap rate. It is the net operating income of a stabilized property divided by the value (sale price) of the property.
Let’s use a simple single tenant fast-food restaurant development (QSR) as an example. First, a developer will need to determine how much it will cost to develop the project. We will call the total cost to build the project the Initial Project Cost. This will include both hard costs and soft costs. Let’s assume it costs $1.75MM dollars to build the fast-food restaurant. Let’s also assume that it’s an absolute NNN lease, meaning that tenant pays all of the operating expenses, and the annual rent in year one is $150,000. Since it is an absolute NNN lease there will be no leakage; therefore, our NOI is $150,000. To determine the going-in cap rate, we will use the above formula. By using the above formula, we have determined that the going-in cap rate is 8.6% (see table below).
After we’ve determined the going-in cap rate, we must determine out going-out cap rate. Again, we do this because we need want to find the spread–the difference between the yield-on-cost and the exit cap rate. The going-out cap rate will be set by the market. In the case of this QSR development, you would find what the market cap rate is for this type of asset. Make sure that you are comparing this to other newly-developed properties with similar geographic characteristics and lease terms and the same tenant. We’ve found a bunch of comps and we’ve determined that these assets are trading at around a 6.5% cap rate.
When we know the cap rate and the NOI, we can easily solve for the projected Sale Price (NOI / Cap Rate). By doing so we see that the projected sale price is $2.3MM.
As with most investments, developers rely on the spread to determine the potential profit from the investment. Developers typically seek a 150-200 basis point development spread.
To calculate the development spread, you will take the difference between the going-in cap rate and the going-out cap rate. Remember that 100 basis points is equal to 1%. In this case we find that the project will return a development spread of approximately 205 basis points (just over 2%). Not bad!
The profit margin is another quick metric developers will turn to when they know the going-in cap rate and the going-out cap rate. The formula is simply the going-in cap rate divided by to going-out cap rate minus 1 (see table below)
Developers typically seek between a 15-25% profit margin. If the margin is below 15% then the profit likely isn’t worth the time and risks of the project. Developers will likely pass and pursue something that will yield greater returns.
After performing this BOE analysis, we can conclude that this is an opportunity worth pursuing. At this point, a developer will refine the projected costs of the development and then run a discounted cash flow analysis to further vet the opportunity. This is a must-know commercial real estate concept, so reach out to me if you have any questions.