Assessing Risk and Return in Commercial Real Estate Investments with Development Spread

When allocating capital to commercial real estate, especially for properties like shopping centers, understanding risk is crucial. Unlike easily quantified metrics, risk in commercial real estate is often assessed on a relative basis. This is where the concept of “development spread” comes in with commercial real estate investment analysis.

Development Spread: A Quick Risk-Reward Gauge

In ground-up developments or value-add projects, the development spread is a simple calculation that helps determine if the potential reward justifies the inherent risk. It’s essentially the difference between the “going-in cap rate” (the property’s cap rate at purchase) and the “going-out cap rate” (the projected cap rate at sale).

Here’s a breakdown of the components:

• Going-In Cap Rate (Yield on Cost): This is the stabilized Net Operating Income (NOI) divided by the total project cost (development) or purchase price plus renovation costs (value-add projects).
  
• Going-Out Cap Rate (Sell-to Cap Rate): This is the projected stabilized NOI in the year of sale divided by the estimated sales price. Since sales might occur years later, estimations are necessary.
  

Interpreting the Development Spread

A natural question arises: what constitutes a “good” development spread? There’s no single answer, as various factors influence it.

• Property Type: Office buildings generally carry more risk than multifamily properties.
• Class: Class A assets (newer and luxurious) tend to sell for a higher price per square foot compared to Class B or C.
• Occupancy: Properties with higher occupancy typically sell for more than those with lower occupancy.

Generally, lower cap rates indicate lower risk, while higher cap rates suggest a riskier investment. A development spread of 1.5% or higher is usually considered desirable.

Development Spread and Risk-Return Relationship

There’s a strong correlation between risk and return in commercial real estate investments. The perceived risk associated with a property is linked to the potential ROI of commercial real estate. These factors are reflected in the property’s cap rate and, consequently, the development spread. A larger spread signifies a riskier project, while a smaller spread indicates lower risk.

For instance, a project with a potential development spread of 5% might seem very profitable. However, it also suggests the market perceives the development or renovation to be riskier compared to a project with a 2% spread. There’s a higher chance of unforeseen circumstances impacting the actual return.

Development Spread in Action: A Case Study

Imagine an investor considering two properties:

• Property 1: A fully occupied mixed-use space outside a major city with established tenants and positive cash flow. The pro forma shows a stabilized NOI of $200,000 and a purchase price of $2.85M, resulting in a going-in cap rate of 7%. After a 10-year hold, the projected NOI is $270,000 with a projected sales price of $4.15M, translating to a going-out cap rate of 6.5%. The development spread for this stable property is 0.5%.
  
• Property 2: A run-down retail space in a southern suburb with high vacancy and short-term leases. It’s currently losing money. While the potential stabilized NOI is $200,000, the purchase price is $1.6M. The investor plans to invest $500,000 in renovations, bringing the total cost to $2.1M. This translates to a going-in cap rate of 9.5%. After 10 years, the projected NOI and sales price for this retail building are also $270,000 and $4.15M, respectively, resulting in a going-out cap rate of 6.5% and a development spread of 3%.
  

The key question revolves around the risk-reward trade-off. Is the potential upside of a 2.5% higher development spread worth the risk of a major renovation and lease-up for this investor? The answer depends on their risk tolerance. An experienced investor might be comfortable, while a new investor might prefer a less risky option.

Development Spread and Profitability

The development spread calculation can also be used to estimate an investment’s potential profitability. This is done by dividing the going-in cap rate by the going-out cap rate, minus 1. In the retail example above, the profit margin would be ((9.5% / 6.5%) – 1) = 46.15%. While this might be a good metric for some investors, a more comprehensive analysis is recommended.

Beyond the Back-of-the-Envelope: Discounted Cash Flow Analysis

While the development spread offers valuable insights, it shouldn’t be the sole factor in a commercial real estate investment analysis. It’s a quick and preliminary calculation to help investors and lenders gauge an opportunity’s potential.

For a detailed analysis of a property’s cash flow and potential valuation, a discounted cash flow (DCF) analysis is the industry standard. This process requires more time and information about the property’s income, operating expenses, and loan terms. A DCF analysis is typically conducted after the development spread suggests a project is worth further consideration.

Conclusion

The development spread is a valuable tool for initial assessment in commercial real estate investment analysis. It helps investors understand the potential risk-reward profile of a project based on its purchase and projected sale metrics. While there’s no single “ideal” development spread, aiming for at least 1.5% offers a general guideline. However, it’s crucial to remember that the development spread is a starting point. For a comprehensive understanding of a property’s potential returns and risks, a more in-depth analysis like a DCF is essential before making any investment decisions.