Uncovering the Strategies of Successful Build-to-Suit Real Estate Deal
A build to suit development, also known as a build-to-suit or a design-build project, is a real estate development in which a property or facility is constructed specifically to meet the needs and specifications of a single tenant.
Developers can profit from a development project through the rental income collected from leasing the finished property, as well as the difference between the cost of acquiring and improving the property and the price at which it is sold or leased, known as the ‘spread’ on a deal. The spread in a development project is the difference between the initial return on investment, calculated as the net operating income of the property divided by its market value, and the expected return at the time of sale or lease.
The going-in cap rate is the expected return on investment that a developer targets for a real estate project, based on the net operating income of the property divided by its market value. The going-out cap rate is the actual return achieved when the project is sold or leased. Developers aim to maximize the spread between these two rates, with an average target of 250 basis points (bps), or 2.5%. For example, if a developer expects to sell a building for a 6.00% cap rate, they may aim to build to an 8.50% cap rate in order to achieve a 250 bps spread and maximize their profit.
Below is an example of this type of deal:
Rocky is hired by Chase to build a new bank at a budgeted total cost of $15,000,000. Rocky and Chase agree that the tenant will pay $1,200,000 in rent, which is 8% of the project cost. When the project is complete, Joe sells the building for $21,818,000, which is based on a 5.50% cap rate. As a result, Rocky makes a profit of almost $7,000,000 from this project (~22M – 15M = 7M).