What is yield on cost in real estate?
Yield on cost (YoC) is a commonly used metric in the real estate industry. Property developers and investors use it to determine an investment’s projected profitability.
The yield-on-cost calculation is straightforward. The property’s expected annual net operating income (NOI) is divided by the project cost and expressed as a percentage. This percentage provides investors with a ballpark figure that they can use to evaluate a commercial real estate project’s risk-return profile quickly.
The YoC of a project tells property developers whether the return on investment they can expect to make is worth the risk they will undertake. Of course, it is not the only investment evaluation technique that should be used, but it is a good starting point for property investors.
Yield on cost vs cap rate
The yield on cost and cap rate are popular CRE investment deal evaluation metrics. They are similar in that they use net operating income to measure the risk and reward of a property investment.
But there is a stark difference in the calculations.
The yield on cost, also known as the development yield, is computed by dividing the net operating income by the project cost. On the other hand, the cap rate uses the property’s market value as the denominator.
The YoC of a property provides a picture of the current situation while the cap rate changes with the ups and downs in property valuation.
It is essential to understand why a savvy real estate investor would pay equal attention to both metrics. The yield on cost provides investors with a projected return. It is an estimate based on specific assumptions (the project cost and the NOI). The cap rate tells you the ratio (expressed as a percentage) of the NOI to the property’s current market value.
Trended vs untrended yield on cost
At this stage, it is essential to familiarize yourself with another couple of terms in connection with the yield on cost:
Trended yield on cost: In this variant of the YoC, the project’s returns consider market trends. Hence, they account for growth due to increases in rent and expenses over the period in question.
Untrended yield on cost: Untrended YoC does not consider changing market conditions. In other words, this variant of the yield on cost looks only at the current situation.
Yield on cost formula
The formula for this metric is uncomplicated. However, the accuracy of the result when you solve the formula depends entirely on the extent to which you can rely on the inputs used – the NOI and the project cost.
Take a moment to dig deeper into the numerator-the NOI. The yield on cost calculation uses the stabilized net operating income, which is the income the project is expected to generate after the project is completed and the property is operational. Consequently, the NOI used in the formula is an estimate.
The total project cost refers to all the expenses the real estate investor incurs to get the property into a condition where it can generate a stabilized NOI.
How to calculate yield on cost (YoC)
The yield on cost calculation provides real estate investors with a back-of-the-envelope estimate that tells them whether the property development investment is worth their while. Fundamentally, the metric permits a comparison between risk and reward. It informs investors of the return they can expect and allows them to compare it with the cost they expect to bear.
Yield on cost calculation examples
The following examples consider two scenarios:
- The yield on cost calculation for a development project
- The yield on cost for a value-add project
Development
Consider a development project with the following parameters:
Land cost: $500,000
Hard costs (building construction): $1,800,000
Soft costs (permits, insurance, administrative, etc.): $300,000
Project cost: $2,600,000
Now, assume the property provides an annual NOI of $125,000
The yield on cost can be calculated by applying the formula discussed above:
Value-add
This example considers a value-add project instead of a development project. In a value-add deal, the investor purchases an existing property and makes extensive improvements. The objective is to increase rents and reduce vacancies.
The following is an example of a value-add project:
Purchase of an existing property: $2,000,000
Renovation expenses: $400,000
Project cost: $2,400,000
NOI after renovation: $200,000
What is considered a good yield on cost?
Yield on cost should not be looked at in isolation. Instead, it should be compared to the current market cap rate for the same property type. The following example will explain the idea presented above.
A real estate developer purchases an existing property for $1 million. The investment strategy involves spending an additional $500,000 on improvements and renovations. This fresh investment is expected to increase net operating income significantly. The developer estimates that the stabilized net operating income will rise to $97,500.
Here is the yield on cost calculation:
Purchase of property: $1,000,000
Amount spent on improvements and renovations: $500,000
Project cost: $1,500,000
Stabilized net operating income: $97,500
Was the investment strategy justified? Can a 6.5% development yield be considered good? If the cap rate for the same property type is 5.5%, the development spread works out to 1%, which could be regarded as acceptable.
Factors influencing yield on cost
Various factors impact yield on cost. These include the property’s location, age, the condition of the surrounding properties, and the general economic conditions in the area. Anything that increases the numerator (NOI) or decreases the denominator (project cost) will serve to increase the yield on cost. Of course, the opposite is also true. So, an increase in operational costs will reduce NOI and lead to a lower NoC. By the same logic, a higher project post will result in a lower NoC.
Consider a hypothetical property with a 5% yield on cost. An extensive renovation could boost the YoC to, say, 5.5% or 6%. Of course, this assumes that the increase in rentals post-renovation more than makes up for the rise in the project cost.
Benefits and limitations of yield on cost
The yield on cost real estate metric is helpful for property investors evaluating new opportunities. However, it has its limitations, too. The following table lists the pros and cons of using this tool:
| Benefits | Limitations |
| Helps property developers evaluate an investment proposal. | It is usually computed for a single year, providing a short-term view. |
| Allows the comparison of different investments. | The stabilized NOI is based on assumptions and estimates that could be inaccurate. |
| Useful for calculating the development spread.* | The denominator in the YoC formula (project cost) is also an estimate. |
| A practical and easy-to-use risk assessment tool. | Inadvisable to use in isolation. Macroeconomic factors are also important. |
*Development spread: The difference between a property’s YoC and the current market cap rate.
Investment strategies involving yield on cost
When devising investment strategies, real estate investors would do well to use the YoC as a measure to appraise an investment proposal. But they should use other information as well. This includes:
- The current market cap rate of similar properties
- Expected changes in macroeconomic conditions
- The level of risk they are willing to take
Investors with a greater risk appetite usually seek a higher YoC. Low-risk investors take the opposite approach. Finally, it is critical to double-check the assumptions you make when estimating NOI and the project cost. A mistake here could invalidate your YoC calculations.
Common mistakes to avoid when calculating yield on cost
The YoC you calculate is only as good as the validity of your assumptions. It is easy to go wrong when estimating both the net operating income (the numerator in the YoC formula) as well as the project cost (the denominator). Here is what to keep an eye out for:
Net operating income
This figure is calculated by subtracting operating costs from revenue. You need to arrive at both carefully. As far as revenues are concerned, check if you have included all rental income as well as the ancillary income that could accrue from the property. When calculating operating expenses, ensure you include the following:
- Maintenance charges
- Property management fees
- Insurance costs
- Taxes
- Utilities
Project cost
The sum you spend depends on the project’s scope. It is vital to carry out a careful review and ensure you include all the costs you will likely incur. Some of the typical costs are:
- HVAC costs
- Plumbing and electrical costs
- Building costs
- Permit fees
- Interior decoration and exterior finishes
- Labor costs
The bottom line
The yield on cost is a useful metric for evaluating property investments, but it should be used in conjunction with other information. Investors also need to look closely at market conditions, occupancy rates in the area, and the current market cap rate for similar properties. The best way to assess a real estate investment is to take a holistic approach that considers the YoC as well as other related details.
