Say a building throws off $1.5M of NOI a year. You can buy one like it at the market cap rate, or build one for whatever construction costs. The cheaper way to own that income wins, and the difference between the two prices is what a developer earns, or loses, for building.
The call
The callBuild itbuilding is $4.0M cheaper
Build and sell+$4.0M+19% on cost
Both yields on the same $1.5M of NOI. The orange segment is the spread.
Market cap rate
6.00%
Yield on cost
7.14%
Yield on cost beats the cap rate by 114 bps, which is why building comes out $4.0M cheaper.
What you pay for $1.5M of NOI if you buy and if you build. The dotted line is the market value.
Buy it$1.5M ÷ 6.00% cap = $25.0M
Build it$1.5M ÷ $21.0M cost = 7.14% yield on cost
$0$5.0M$10.0M$15.0M$20.0M$25.0M$30.0M
Purchase price$25.0M
Development cost$21.0MProfit when you sell$4.0M
Costs $21.0M to buildWorth $25.0M at a 6.00% cap
Worth at market$25.0M
Purchase price$25.0M
Worth at market$25.0M
Development cost$21.0M
Profit when you sell$4.0M
Swipe sideways to see all three bars.
Buy it6.00% cap, $25.0M
Purchase price$25.0M
Build it7.14% on cost, $21.0M
Development cost$21.0M
$0$5.0M$10.0M$15.0M$20.0M$25.0M$30.0M
Purchase priceDevelopment costProfit when you sellMore than buying
Costs $21.0M to buildWorth $25.0M at a 6.00% cap
6.00%Buyers pay $25.0M for $1.5M of NOI
4%: buyers pay up9%: buyers want a bargain
$21.0M7.14% yield on cost
$15.0M: cheap land, easy build$35.0M: overruns and delays
What just happened
At a 6.00% cap a buyer pays $25.0M for $1.5M of NOI. Building the same thing costs $21.0M, which works out to a 7.14% yield on cost, 114 bps above the market. If you build it and then sell it at the market cap, you clear $4.0M, about 19% on cost. That $4.0M is what you get paid for taking on the construction and its risk.
Relevant formulas
Market valueNOI divided by the cap rate$1.5M ÷ 6.00% = $25.0M
Yield on costNOI divided by the all-in development cost$1.5M ÷ $21.0M = 7.14%
Spreadyield on cost minus the cap rate7.14% − 6.00% = +114 bps
Build and sellmarket value minus the cost$25.0M − $21.0M = +$4.0M
Margin on costprofit divided by the cost+$4.0M ÷ $21.0M = +19%
All-in cost means land, construction, fees, and the interest paid while building. The picture values the finished building today and leaves out the years of building and the risk that rents, costs, or cap rates move in the meantime.
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