What is Development Spread?
Development spread in real estate development feasibility refers to the difference between the projected return on cost (ROC) for the development and the market yield or capitalization rate for similar properties. It is used as a key metric to assess the potential profitability and risk of a project.
Development Spread Formula
Development Spread = ROC - Market Yield (Cap Rate)
Where:
- Return on Cost (ROC) = (Total Project Revenue / Total Development Cost) - 1
- Market Yield/Cap Rate = Market-derived percentage representing the income yield of a stabilized property.
What Does development Spread Tell Us?
- Profitability: A positive development spread indicates that the project is expected to generate a return higher than the market yield for similar properties, suggesting it’s profitable.
- Risk Profile: A large spread suggests a buffer, indicating that the project has room for overruns or delays while still being profitable. A small spread might indicate a riskier project with less margin for error.
- Feasibility: Lenders and investors use the development spread to assess if the potential rewards justify the inherent risks of the project.
What is a Good Development Spread?
Lenders typically look for a development spread of at least 1.5% to 2% above the market yield to account for the risks and ensure profitability. For instance:
- If the market yield is 5%, a good development spread would result in an ROC of at least 6.5% to 7%.
- In riskier projects or markets, lenders may look for an even higher spread to provide a greater margin of safety.
The ideal spread can vary based on the type of property, market conditions, and the specific lender’s risk tolerance. However, a spread that’s too narrow might make financing harder to secure, while a wide spread could indicate strong financial viability.