Development · Value-add
Yield on Cost Against Exit Cap: The Only Spread That Matters on a Conversion
If you report one number from a value-add or conversion deal, report this one. It survives contact with an investment committee.
On a stabilized acquisition, the cap rate tells you most of what you need. On anything where you are spending money to change the income, a conversion, a lease-up, a renovation, the cap rate on the purchase price is close to meaningless, because the price is not the cost and the current income is not the income you are buying.
The measure that works is yield on cost: stabilized net operating income divided by everything you spent to get there. Purchase price, closing costs, tenant improvements, landlord work, leasing commissions, loan fees, capital funded at closing. All of it.
The spread is the deal
Compare that yield to the cap rate you expect to sell at. The difference is your development spread, and it is the reason to do the deal at all: you are manufacturing a stabilized asset for less than one costs to buy.
Manufacture at a 9 percent yield on cost and sell at a 7.5 cap and you have created value equal to the difference, capitalized. Manufacture at 7.6 and sell at 7.5 and you have taken development risk, spent eighteen months, and produced roughly what you could have bought passively on day one.
How much spread is enough
Under about 100 basis points there is no tolerance for anything going wrong, and something always does. Permitting runs long, the tenant asks for more allowance, the roof fails inspection. Every one of those consumes spread.
Between 100 and 150 basis points the deal works if the schedule holds. Above 150 there is real room. Those are rules of thumb rather than laws, and they tighten in a market where exit caps are widening.
Why report this instead of IRR
Because IRR is a function of assumptions stacked on assumptions, and it moves when you change the hold period. Yield on cost against exit cap is two numbers, both traceable, and a committee can interrogate them. "We build to a 9 and the market pays a 7.5" is a defensible sentence. "The IRR is 14 percent" invites a question about what is inside it.
Both are in the models: Vacant pharmacy box and multifamily model with a renovation program report yield on cost, development spread and the exit cap at which the spread disappears.
Related notes
How to read this. These are working notes. Figures come from public reporting and from the models on this site, and market conditions change, check anything time-sensitive against the source before you rely on it. Nothing here is investment, tax or legal advice, and no note is a substitute for diligence on a specific property.
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