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Yield on Cost (YOC) is a financial metric you can use to evaluate the performance and profitability of a real estate investment. By determining your project’s yield on cost, you can measure risk against potential return and compare the asset to other potential opportunities. The yield on cost is unique from other financial metrics in its ability to evaluate an asset’s returns based on initial construction and development costs.
In real estate, yield on cost is used to provide investors with an accurate understanding of how initial capital is leveraged over time and make comparisons with other properties without factoring in appreciation or depreciation that has occurred since acquisition. The yield on cost is, therefore, a useful equation to assess a property’s historical performance and help investors make decisions about future purchases.
Here’s everything you need to know about yield on cost in real estate development, including the formula for your calculation, practical applications, and incorporating the metric into your investment strategy:
Understanding Yield on Cost
In simplest terms, you can define yield on cost as a financial metric that measures the risk and return profile of a real estate asset. Investors calculate yield on cost to compare the potential return on a property investment to the total cost incurred. Yield on cost is a practical metric to ensure a project's return on investment (ROI) is greater than the amount invested upfront.
So, what is the function of yield on cost in real estate development? You’ll likely use this metric to assess financial performance, mitigate risk, and ensure projects are profitable. Yield on cost calculation can ultimately help you make informed pre-development decisions, attract potential investors to a project, and conduct long-term planning such as capital expenditures, refinancing, or exit strategies on a given project.
Trended vs. Untrended Yield on Cost
The trended yield on cost is a property’s yield with financing and growth projections. In contrast, an untrended yield on cost is an asset’s return on investment after purchasing costs and renovation expenses. Untrended yield on cost allows you to look at a property’s return without financing and without considering major growth due to market trends. Finding this calculation is essential to see how much the cap rate will increase after improvements.
How to Calculate: the Yield on Cost Formula
The yield on cost is calculated by taking the net operating income (NOI) and dividing the figure by the total project cost. Net operating income is found by subtracting all of a property’s operating expenses from all the revenue generated by the property. Total project costs are determined by finding all expenses associated with the acquisition and development of a project.
Here’s the simple formula used to calculate the yield on cost:
Yield on Cost = Net Operating Income/Total Project Cost
In your calculations of yield on cost it's important to note that when calculating the yield on a property investment, NOI is used on a pro forma basis. In other words, the income and expenses of the property are being projected or estimated in the future.
Yield on Cost vs. Cap Rate: The Distinction
Investors should be aware of several key distinctions between cap rates and yield on cost; the metrics serve a similar function, but the financial metrics have a few key differences.
Cap rates look at market value, but yield on cost looks at costs. The calculation for cap rate is found by dividing the net operating income by the asset sale price. The yield accounts for the building’s income divided by its total cost, including renovation dollars. Cap rates look at value, which is subject to change. Yield on Cost looks at costs, which are fixed.
Yield on Cost and cap rate also focus on two different things. Cap rate is intended to show the property’s current performance and its ability to be an income-producing asset in the current market. In contrast, yield on cost looks at the historical cost of the property and is meant to help investors determine the performance of an asset over time and its long-term value. In a down market, a cap rate may compress while yield remains high as long as rents remain strong and the property was acquired before appreciation.
Each metric will also serve a different purpose for investors. Cap rates are used to assess a property's potential value, compare different properties to determine which might deliver the highest return on investment (ROI), and to determine how attractive an asset is in the current market.
Yield on Cost helps investors quantify risk in purchasing an asset by evaluating the profitability of a property based on historical investment cost. Investors use the yield on cost to make decisions about property improvement, long-term holding, or whether or not the asset is aligned with their financial goals.
Practical Application: Yield on Cost in Action
By taking a look at two hypothetical development scenarios, you can better understand yield on cost in action and how it can help your development strategy. In order to better understand the equations below, work off the assumption net operating income (NOI) and total project costs have already been calculated.
Net Operating Income: $2,240,000 $2,460,000
Total Project Cost: $23,700,000 $19,400,000
Yield on Cost: 9.5% 12.6%
Once you have used this calculation to determine the yield on cost, you can compare that metric to comparable deals in the market and make sure the potential returns are on track.
Different metrics are likely to paint a very different picture of a given project’s potential performance, and though the yield on cost real estate calculations are useful, it may be just one component of your decision-making process.
Incorporating Yield on Cost into Investment Strategies
Yield on Cost will prove most valuable when used in conjunction with market analysis, allowing you to compare the stabilized yield on cost rate to the market cap rates to determine whether a project is a sound real estate investment. The downside of yield on cost is that it doesn’t reflect additional considerations, such as macroeconomic conditions, location, building conditions, or occupancy rates. The metric also can’t account for future changes to an asset, such as renovations and upgrades or market fluctuations.
Investors may or may not choose to prioritize yield on cost in their decision-making based on individual risk profiles. Low-risk investors, who have a conservative approach and prioritize stability over the potential for high returns, will opt for projects with a low yield on cost. High-risk investors who have a high tolerance for risk and can weather significant losses in their portfolios in order to secure long-term returns will be more likely to pursue projects with high yield on cost.
Modern real estate development software like Northspyre can be a powerful tool for modeling budgets, mitigating risk, and boosting returns on development projects. Northspyre provides you with actionable analytics, ensuring all your project data is tagged and indexed to enable quick and easy searching in contracts, proposals, and change orders so you can make data-driven decisions across your portfolio. Real-time alerts identify a budget overrun or contract overspend, allowing you to adjust your budget and ensure accurate forecasting.
Northspyre’s command center has additional functionality to help you assess risk in pre-development. The platform’s DeepLook feature allows you to leverage budget recommendations and ensure you know what projects should cost based on your project location, budget, and asset class, among other factors.
Yield on Cost (YOC) has an evolving role in real estate decision-making, and its focus on historical and fixed costs can make the metric especially useful in deal comparison scenarios. In order to get a holistic view of a project’s success, YOC is most reliable when used in conjunction with thorough market analysis and as you leverage modern real estate development tools to budget scenarios.
Download our ebook How to Cut Real Estate Development Costs by 2-6% to learn more about boosting returns and outperforming the competition.
Tag(s): Real Estate Development
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