There are several metrics in analysing a property investment or a property development proposal,
particularly on a construct-and-retain basis; one of which is called Development Spread.

The best way to describe Development Spread is that it’s a good, old-fashioned back-of-the-envelope
calculation that old-school property developers use (and some younger ones, too). It’s a basic acid
test to determine how profitable a proposed property investment project may be.

In more technical terms, a Development Spread is a calculation to determine the spread (ie;
difference) between the entry and exit capitalisation rates or dollar values.

The reader may already be familiar with the term “spread” as it also describes the difference between
a BBSY bid and BBSY call rate, where the mid-rate (BBSW) is midway in the spread.

What that means is basically the profit, ie; the ratio of net project income to project cost. The
calculation is effectively the net project income divided by the total project cost (“TPC”).

To put this into practical terms, the:

1. entry yield or incoming yield is the post-completion and letting-up return at which a property is
valued:
a. initial net rental income of, say $480,000 (net of GST, incentives, and letting up allowances,
as the case may be) which is then divided by the TPC of, say $9,500,000 being the acquisition cost of a vacant property + refurbishment or fit-out + letting up costs of the property which results in a capitalisation rate (may also be referred to as an “initial yield”) of 5.05% which is typically within  a general average in the current market for a commercia-retail investment property.

2. exit yield, or final yield, is the anticipated final net income of the subject property at a proposed
disposal date at the end of the investment term, divided by the market value at that time.
This may be a function of end of incentives and the effecting of annual or market reviews to the
initial rents.

The exit yield calculation is the same as for the entry yield, ie:

a. the mature or final rental income of, say $600,000 after 3 years (when incentives have lapsed
and annual & market reviews have been implemented, which is then divided by the determined market value, or, anticipated or actual sale value less sales  commission and marketing costs, say $14,800,000, results in a final or terminal yield of 4.05% which is typically within the general average in the current
market for commercial-investment property.

b. Now, we can calculate the Development Spread as the entry yield minus the exit yield, which in the
above example is 5.05% – 4.05% = 1.00%.

c. The basic, alternative way to calculate the simple profit is to subtract the entry cost from the exit or
sale and divide that figure by the entry cost, eg; ($14,800,000 – $9,500,000) / $9,500,000 = 55.7%
return on TPC (or a $5,300,000 project profit in dollar terms).

Obviously, a project’s viability expressed by calculating the Development Spread will depend on the
type and risk profile of a project, where the purchase of a vacant property for cosmetic enhancing
and letting up would be less risky than a knock-down and new construction project; one would seek
a higher development spread commensurate with the higher risk.

There are several other methods of determining project returns and property values, please refer to:
In JP’s Kitchen — LINK Commercial Mortgages (linkcm.com.au) and view the video and download the
discussion paper.

Contact LINK today should you wish to obtain assistance in calculating the feasibility of a project that
you may be contemplating, how to optimise your project return, and take advantage of our services
and property specialist referral partners.

Disclaimer

The information in this article is of a general nature and is not intended to address the circumstances of any particular individual or  entity. Although we endeavour to provide accurate and timely information, we do not guarantee that the information in this article  is accurate at the date it is received or that it will continue to be accurate in the future.