Where does a thin spread on an industrial build actually break?

Question

Take an industrial ground-up build and work through whether it is even the same discipline as small multifamily. Land at 1.2M for about 4.5 acres. Hard cost pencils at 145 a square foot on 60,000 square feet, so 8.7M, plus soft costs at roughly 15 percent, landing near 11.2M all in, about 187 a square foot. Market asking on comparable shallow bay space is 12.50 NNN. At 5 percent vacancy and credit loss, NOI lands near 700k, putting yield on cost at 6.2 percent. Local shallow bay trades around a 5.75 cap, so the spread over exit cap comes to 45 basis points. That spread can feel thin for two and a half years of construction risk and a completion guarantee, and the honest answer is that where a number like this breaks depends heavily on how much cap rate movement, cost overrun, and lease-up delay a sponsor can absorb before the spread disappears entirely. A rule of thumb worth applying broadly: the thinner the spread over exit cap, the more the deal is a bet on execution and timing rather than on the fundamentals of the asset, and that bet deserves to be sized and stress tested accordingly before committing capital.

Rena Expert · Accepted Answer

45 basis points isn't a spread, it's rounding error. Merchant builders in industrial have generally wanted 150 to 200 basis points of yield on cost over the cap they expect at exit, and the reason isn't greed. It's that the exit cap is the single input you have the least control over and it's being estimated two and a half years forward.

Do the sensitivity. At 5.75 you're worth $12.17M against $11.2M of cost, so about $970k of value creation, an 8.7 percent margin on cost. Push the exit to 6.5, which is well inside the range caps have moved in a normal 24 month stretch, and you're worth $10.77M. The project is underwater and you've personally guaranteed completion. That asymmetry is the whole answer to your question.

The $145 hard cost needs interrogation too. Confirm what structural system it assumes and what clear height. Tenants asking $12.50 on shallow bay usually want 28 to 32 foot clear now, and if your number was built off a 24 foot building you're short. Steel-intensive scopes have carried real embedded tariff cost per square foot, and the only way to hold that line is buying out steel early, ideally at GMP with the joist and deck package locked before you close the loan.

Two things your model probably doesn't have. One is the interest reserve sized for a lease-up period, not just construction. Spec shallow bay can sit six to twelve months after CO, and someone funds the carry. The other is TI and leasing commissions on a spec building, which for multi-tenant shallow bay is not zero, and if you're splitting 60,000 feet into four bays you're paying for demising walls, extra dock positions, and separate offices that a single-tenant pro forma never included.

karen_whitfield · Answer

The land basis is where I'd push. $1.2M on 4.5 acres is about $6/sf of dirt, which for shallow bay in a market where product trades at a 5.75 doesn't sound cheap enough to carry a 6.2 yield. Land is the one input you buy before you're committed to anything. Every dollar you overpay there shows up in the yield forever and can't be value engineered out later.

samantha_ruiz · Answer

This is exactly the ceiling I keep running into. Everything I underwrite comes out between 6.1 and 6.3 on cost, and every construction lender I talk to wants to see something north of 6.75 before they'll size at 60 percent. So the deal doesn't die on my math, it dies on theirs. @renee_dubois have you actually shown the 6.2 to a bank yet? I'd be curious whether they laugh or whether they counter with a lower LTC and more recourse.

paulgrant17 · Answer

What does the NNN in $12.50 NNN cover? Is the tenant paying taxes and insurance on top of that, or is that already in the 12.50?

Rena Guide · Answer

@paulgrant17 NNN means triple net, so the $12.50 is base rent and the tenant separately reimburses property taxes, insurance, and common area maintenance. A gross rent would have those inside the number, which is why you can't compare a gross quote and a net quote directly.

Since a few terms in this thread go past their usual definitions, the two doing the most work here are worth being precise about. Yield on cost is stabilized NOI divided by total project cost, so it answers "what return does the finished building produce on every dollar I put into building it." Cairn's 6.2 percent is $700k over $11.2M. A cap rate is NOI divided by what a buyer pays, so it's what the market charges for an already-finished building. Development spread is the gap between the two, and it's the compensation for taking construction and lease-up risk instead of buying something already leased.

The reason 45 basis points reads as alarming to the operators here is that it's smaller than the ordinary error bars on the inputs. A construction budget can miss by 5 percent without anyone doing anything wrong, and 5 percent of $11.2M is $560k, which is more than the entire spread is worth. When people say a development is "underwritten to the contingency," this is what they mean. The margin only exists if nothing moves.

omar_haddad · Answer

5 percent contingency on $8.7M of hard cost is $435k. On renovation I won't go below 10 and I still get surprised. Ground up has fewer unknowns behind walls, sure, but it has all of them in the ground. Unsuitable soils, rock, a wet spring that pushes the pad and then the whole schedule. Ask your geotech what the undercut allowance is and whether the number in your budget matches what the borings suggest, because that single line has eaten more of my contingency than anything else.

gregpowell66 · Answer

@renee_dubois get the structural system in writing before trusting $145. A pre-engineered metal building and a tilt-up concrete building are different money and different lease-up stories, and tenants in shallow bay increasingly want the concrete. Joist and deck lead times tend to be the schedule driver on these builds rather than permits, and a mill quote holds for a fixed window that is shorter than a typical closing timeline. Without buying out steel early you are carrying escalation risk on the largest single trade in the building. Also, 60,000 feet on 4.5 acres is a 30 percent coverage ratio. Check the local parking and truck court requirements before assuming that fits, because a 130 foot court plus a drive aisle eats land fast.

ryanmck27 · Answer

Nobody's put a number on the leasing side. Commission on industrial in most markets runs a few percent of gross lease value over the term, and on a five year deal at $12.50 across 60,000 feet you're talking real dollars, plus the tenant rep's half. On a spec building you pay that at signing, out of a budget that already has a 45 basis point cushion. @renee_dubois is that line in your soft cost 15 percent or outside it?

aaron_fitz10 · Answer

The comparison that lands hardest in this thread is that a buyer could pick up a leased shallow bay at a 5.75 today with no completion guarantee and no 30 month clock, while cairn's project produces 6.2 if everything goes right. Those 45 basis points are the entire payment for taking on construction and lease-up risk. An operator without the balance sheet to absorb a long delay, or the stomach for one, usually comes out ahead by buying the stabilized building.

jessreyes12 · Answer

Basic question about the interest reserve since it came up twice. Is that money the lender holds and disburses to itself for the interest payments, funded out of loan proceeds, so it counts against my LTC? And if lease-up runs past what the reserve covers, do I write checks monthly or does the loan just go into default? I've never had to look at that mechanism.

hannah_west29 · Answer

Take cairn's numbers across a range of exit caps. At 5.50 the building is worth $12.73M, so $1.53M of margin, 13.7 percent on cost. At 5.75 it is $970k. At 6.25 it is $40k, essentially free work for three years. At 6.50 it is negative $430k and the completion guarantee is the only thing between you and a bank. What that distribution says is that the project is a leveraged bet on cap rates staying where they are, with a construction job attached, and calling it an industrial development flatters it. If that is the bet you want, there are cleaner ways to make it.

Where does a thin spread on an industrial build actually break?

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