“I’d rather build to a 7% and sell at a 5% than buy a straight 5%...” said every developer ever. What does this all mean? Let’s start by defining Yield-on-Cost (YOC). This is a metric that is the same math as a cap rate, except it’s highly speculative because it involved development. The calculation is generally defined as the stabilized pro forma NOI divided by the total basis (total cost) of the development.
Let’s take this a step further. Developer Sam has identified a plot of land for future multifamily development. He does a comp survey and understands that stabilized multifamily product in the area is trading (selling) around a 5.0% cap rate. That is, sophisticated investors are buying built and stabilized product for 5.0% yields. How does Developer Sam earn a profit for taking on the added risk of development? He has to “build” his deal to a stabilized yield greater than the prevailing market cap rate of 5.0%.
To better understand this, let’s use a simple example. Investor Smith bought a multifamily property 10 years ago at a 7.0% cap rate (yield) with a $500,000 NOI. Due to cap rate compression, the market is now bearing a 5.0% cap rate. Investor Smith hasn’t really done much work to raise rents or lower expenses at the property so his NOI has remained the same (for the purposes of this example) for the entire 10 year investment period. Now, Investor Smith decides to sell his property at a 5.0% cap rate. Let’s examine the math below to see how Investor Smith earned a $2.9 million profit only due to cap rate compression.
Going back to the development scenario with Developer Sam - let’s understand how developers earn a profit or “add value” to real estate deals. Developers also try to build to yields (or cap rates) higher than the current market, sometimes called a “spread premium” to market cap rates. This concept is identical to what we saw above with cap rate compression. Assume Sam thinks he can build a property for total costs of $7,142,857. He also assumes that the stabilized NOI for this type of property based on market rents and expenses will be $500,000. Once Sam builds the property, leases it up, and stabilizes it, he can turn around and sell the deal to a normal investor for a 5.0% cap rate (or $10 million).
In this example, in exchange for the risk he took to develop a building from a raw parcel of land, Developer Sam would earn $2.9 million of profit. Higher risk usually equals higher reward; higher reward usually means higher return. In essence, Sam’s developed his investment to a higher yield (higher return) due to the increased risk (development). In a nutshell, these are the economics of development deals.