Yield on Cost Metric in Real Estate: A Hidden Gem
The yield on cost is an underappreciated financial metric that can give deep insights into a commercial real estate investment.
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What is Yield on Cost?
The yield on cost (YOC) looks to answer one big question:
What is the CRE investment’s annual yield on a total project cost basis?
This metric is somewhat of a hybrid of the capitalization rate (cap rate) and cash-on-cash yield.
A cap rate will look at the property’s net operating income (NOI) and divide it by the purchase price of a property. A cash-on-cash yield will look at cash flow after debt service divided by the purchase price plus capital expenditures (CAPEX).
The YOC will look at the NOI and divide it by the purchase price plus any CAPEX.
YOC Terminology
You may hear yield on cost called:
Return on Cost (ROC)
Development Yield
Net Yield
All terms mean the same thing and are used interchangeably. I have always internally designated development analysis and individual unit analysis in value-add as “return on cost” (much more on this later).
For repositioning efforts on existing multifamily properties, I think of the metric as the “yield on cost.” I don’t have a good rationale for this distinction; it’s just how my mind works.
Regardless, the terms are interchangeable and look to answer the same question—What is your annual yield on total dollars spent?
YOC vs. Other Metrics
Let’s say a property has the following high-level numbers:
Let’s calculate the cap rate, cash-on-cash, and YOC.
The cap rate calculation:
$285,000 / $5,000,000 = 5.70%
$57,000 / ( ($5,000,000 +$1,000,000) x 25%) = 3.80%
The YOC calculation:
$285,000 / ($5,000,000 + $1,000,000) = 4.75%
The cap rate formula is misleading because it doesn’t account for the $1,000,000 in CAPEX spending. While it may look like a reasonable cap rate (high) at the surface level, if other comparable properties trade around a 5.70% cap but don’t need a million-dollar renovation, this property is likely misvalued.
The cash-on-cash formula offers much more detail but is very dependent on financing. Questions like:
What is the loan amortization?
Are there any interest-only years?
These will significantly impact annual debt service and the cash flow after debt.
The YOC is an excellent middle ground. It factors property value and CAPEX but doesn’t include data from the financing election/terms.
YOC Best Uses
All investment metrics serve a purpose for real estate investors, but there are some instances where YOC stands out as the prominent metric. I include YOC calculations in three different Tactica financial modeling Excel tools:
Development
In development, the YOC is arguably the most vital metric to track. In the actual model linked above, I refer to it as the “Return on Cost,” and I’ve heard others call it the “development yield” or “net yield.”
The yield calculation is:
YOC = Stabilized NOI / Total Development Cost
If you project the NOI at stabilization as $2,500,000 and development costs at $42,000,000, the YOC is calculated as follows:
$2,500,000 / $42,000,000 = 5.95%
The YOC is very powerful compared to the market cap rate. If the market value of Class “A” new construction multifamily is 4.50% (vetted with sales comps), you should be excited about this project.
5.95% > 4.50%
The delta between 5.95% and 4.50% is the development spread (your potential profit when it comes time to sell the asset). The more significant the gap between the YOC and market cap rate, the higher the probability that your project will be profitable.
If the market value for newly constructed apartment builds was 6.00%, you’d need to consider moving forward with the development.
5.95% < 6.00%
Why would taking on a construction project (and all the development risks) make sense when you could purchase a new apartment complex at the same price?
Multifamily development is about building a new project for cheaper than you could sell it for once it’s completed. The YOC is the metric that answers this question (assuming you have a good pulse on the market and pertinent sales comp data).
In the Tactica Multifamily Development Model, we have a sensitivity test that shows you the YOC in the development proforma and how the yield on cost changes at different NOI and construction cost thresholds.
We also include a simple YOC calculation in the free “Back of Napkin” Development Template.
Value-Add
The yield on cost calculation in the Value-Add Model is unique. Instead of looking at the entire property, I’m more curious about the rate of return for the renovations of each residential unit. If you’re studying the local rent comparables, you know different unit types will command varying market rents. Ideally, you can project how much a unit renovation will cost and how much monthly premium you’ll collect.
You can see that the financial model is returning a “return on cost” for each unit type. The one-bedroom units aren’t as lucrative as the larger floorplans (15% ROC vs. 22.5%).
Realistically, a property manager needs to make many small decisions to improve the rental property and ideally see an increase in annual rents. It could be spending money on value-add investments to increase rental income or on a capital project to reduce future operating expenses (for example, investing in LED lighting to reduce the future electricity bill).
Looking at the return on investment more granularly could help decide if it’s worth pursuing. Will the YOC be more significant than your projected internal rate of return (IRR)?
Is YOC > IRR?
If so, pursuing the improvements will likely make sense as they will benefit your overall investment returns.
In the image above, the ROC for all units is projected at nearly 21%. That is much higher than the projected leveraged and unlevered IRR and, if executed, would lead to a higher residual valuation.
We include a YOC calculation in the free “Back of Envelope” Multifamily Analysis Template.
Redevelopment
You can find the final example of YOC in the Tactica Redevelopment Model. The Redevelopment Model is for messy, distressed multifamily properties requiring extensive renovations. While the model includes cap rate calculation, they aren’t helpful if a property is severely underrated, largely vacant, and distressed with deferred maintenance.
A property could technically be a 2.00% cap if it’s 40% vacant. In these situations, cap rates are largely irrelevant.
The “Stabilized Yield on Cost” takes:
Stabilized Net Income / Total Uses
Stabilized net income occurs when the renovation is complete, and units are leased. Stabilization occurs in Year 3 of the sample proforma from the image above.
“Uses” include expenses to finance, close, and renovate the investment property.
Purchase Price
Renovation Capital
Interest Reserve (if any)
Escrow and Closing Costs
Financing Costs
Other Costs
Year 3 Stabilized NOI = $993,743
Total Costs (Uses) = $15,158,115
YOC = $993,743 / $15,158,115 = 6.56%
Like the development scenario laid out earlier, you should compare the YOC to the cap rates, which should be higher. Your future profit will be the spread between the YOC and the market cap rate.
If YOC > Market Cap Rate
You are in good shape, and the probability of profit is elevated (assuming you execute your redevelopment business plan).
Exploiting the Yield-on-Cost Metric Video
Summarizing Yield on Cost
YOC is a helpful metric for capital-intensive projects. Cap rates are flawed because they don’t account for any CAPEX spending. The cash-on-cash return is an insightful metric but isn’t great for benchmarking due to the effect financing assumptions will have on the cash-on-cash return. YOC is a great compromise that is insightful and great for benchmark analysis.
YOC is most effective when you are an expert on the surrounding market and can compare the stabilized YOC to the market cap rates to assess whether the project is worthwhile.
