What is Development Spread?
Development Spread refers to the difference between a project’s stabilized yield (also known as Yield on Cost) and the prevailing market cap rate (capitalization rate) for comparable stabilized assets. It is a key metric used by developers to assess the profitability and risk of a development project.
Formula for Development Spread
Development Spread = Yield on Cost (YoC) − Market Cap
Where:
- Yield on Cost (YoC) is calculated as:
- Market Cap Rate represents the capitalization rate for similar stabilized properties in the market. It is the expected rate of return based on the current income of the asset.
Significance of Development Spread
- Profitability Indicator: A positive spread indicates that the project will generate a higher return than similar stabilized assets, meaning the development is likely to be profitable.
- Risk Assessment: A negative spread or a spread that is too small may indicate insufficient returns to justify the development risks, including construction costs, time, and market changes.
- Investment Decision: Developers use development spread to make investment decisions. A larger spread suggests higher profitability and lower risk relative to holding a stabilized asset or buying an existing property.
Good or Bad Development Spread
- Good Development Spread: Generally, a development spread of 100 to 200 basis points (1% to 2%) is considered good. It shows that the developer is achieving returns significantly above market cap rates.
- Bad Development Spread: A spread below 100 basis points might indicate that the project has minimal margin for error and may not justify the development risks. Negative spreads (when YoC is less than the market cap rate) suggest that the project would yield a lower return than simply purchasing an existing asset.