The yield on cost is a critical metric in evaluating real estate development and value-add projects. This ratio helps investors and developers assess the potential profitability of a project, enabling informed decisions about investments. In this article, we’ll delve into the concept of yield on cost, explaining its importance, calculation methods, and offering examples to aid your understanding.
Here’s what you’ll learn:
- What is Yield on Cost?
- Yield on Cost Formula
- How to Calculate Yield on Cost
- Yield on Cost Calculation: Development Example
- Yield on Cost Calculation: Value-Add Example
- Yield on Cost for Specific Value-Add Projects
- Yield on Cost and Development Spread
- Yield on Cost vs Cap Rate
- Yield on Cost Limitations
What is Yield on Cost?
The yield on cost is widely employed by commercial real estate professionals to measure the return on real estate developments or value-add projects. This metric is particularly useful in determining the development spread—the difference between yield on cost and the market cap rate for similar existing properties in the same market. A positive development spread indicates that a project may deliver additional returns relative to existing properties.
In essence, yield on cost indicates how much return an investor can expect to gain from a project compared to its overall cost. It is also referred to as the going-in cap rate, development yield, return on cost, cost cap rate, or build-to rate according to context.
Yield on Cost Formula
The formula for yield on cost is straightforward: it is the stabilized Net Operating Income (NOI) divided by the total cost of the project. The equation looks like this: Yield on Cost = Stabilized NOI / Total Project Cost.
For instance, if a project forecasts a stabilized NOI of $100,000 and the total cost amounts to $1,000,000, then the yield on cost can be calculated as follows: Yield on Cost = 100,000 / 1,000,000 = 10%.
How to Calculate Yield on Cost
Calculating yield on cost involves practical examples. We will explore how to calculate the yield on cost for both development projects and value-add projects, as well as specific renovations.
Yield on Cost Calculation: Development Example
Let’s consider an example: an investor finds land for developing a small office building, with an estimated total project cost of $3,900,000, comprising land, hard, and soft costs. With an expected stabilized net operating income estimated at $232,400, the yield on cost is calculated as follows:
Yield on Cost = 232,400 / 3,900,000 = 5.9%.
This yield is below the market cap rate of 6.5% for similar properties, indicating the project might not be worthwhile.
Yield on Cost Calculation: Value-Add Example
Next, consider a small multifamily property purchased for $2,500,000 with a renovation budget of $750,000. Post-renovation, the expected stabilized NOI rises to $312,500. The yield on cost is:
Yield on Cost = 312,500 / (2,500,000 + 750,000) = 9.6%.
This yield exceeds the 8% market cap rate for renovated properties, justifying the investment.
Yield on Cost for Specific Value-Add Projects
To assess specific renovations, divide the expected additional NOI by the renovation cost. For example, investing $100,000 in renovations that yield an additional $20,000 NOI results in a yield on cost of:
Yield on Cost = 20,000 / 100,000 = 20%.
If this yield surpasses the property’s original yield, the renovation is likely to enhance property value.
Yield on Cost and Development Spread
The yield on cost aids in calculating the development spread, revealing the incremental return from developing versus purchasing existing properties. For example, a yield on cost of 9.00% with a market cap rate of 7.00% would yield a development spread of:
Development Spread = 9.00% – 7.00% = 2.00%.
Yield on Cost vs Cap Rate
Understanding the difference between yield on cost and cap rate is crucial: while cap rate uses market value, yield on cost calculates potential profitability against total project costs.
Yield on Cost Limitations
While yield on cost is a valuable metric, it relies on a single year’s NOI and may overlook long-term trends and economic fluctuations. To obtain a comprehensive view, it’s prudent to create a multiyear proforma to consider various outcomes throughout the holding period.
Conclusion
In conclusion, yield on cost is a vital concept in real estate investing that offers insight into project viability. By understanding its calculation, significance, and limitations, investors can make more strategic financial decisions in real estate development.
