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In this article we’re going to look at “yield on cost”, one of the widely used metrics in private equity real estate–useful for initially assessing investment returns.
Metrics to assess investment returns
Decisions by private equity real estate investors are driven by, amongst other things, investment returns, and a host of metrics such as “yield on cost”, “yield on value”, “IRR”, “NOI” and “cap rates” are used to measure the attractiveness or viability/feasibility of an investment.
Some of these metrics are used for the initial assessment of an investment return, before a more detailed analysis is undertaken; some used when a detailed assessment is being undertaken.
One widely used metric is the so-called “yield on cost” which is used in the initial stages of assessment when evaluating new or existing multi-family or BTR-SFR projects and/or “value-add” real estate projects, where capital expenditure is committed in order to enhance the value of an asset.
What is the Yield on Cost?
The yield on cost (“YoC”) metric is used to measure the investment return from a real estate development or value-add project based on its cost of development; or the acquisition costs in the event of an existing property being acquired.
It is also used to calculate the difference between the yield on cost and the market based cap rate for similar but already existing buildings in the same market, the so-called “development spread”. The development spread measures the additional return being earned in exchange for taking the additional risks of major construction and/or development.
Other terms used for YoC are the “going-in cap rate”, “development yield”, “return on cost”, “cost cap rate” or “build-to rate”.
Formula used to calculate Yield on Cost
The formula used is simple and calculated by dividing the property’s existing or projected stabilised Net Operating Income (“NOI”) by the expected project or acquisition costs.
As an example, if a property has an expected stabilised NOI of $100,000 with a total development or acquisition cost of $1,000,000, then the YoC would be 10%, or 100,000/1,000,000.
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Yield on Cost and Development Spread
The yield on cost is one metric investors use to calculate the “development spread” of a real estate investment and helps measure the difference between the YoC and the cap rate for existing and already stabilised properties in the same market.
If, for example, the yield on cost for a potential development project was estimated at 8.50% and the average market cap rate for similar, already built and stabilised projects 7.00%, then the development spread would be 8.50 minus 7.00, or 1.50%
This development spread indicates how much additional return an investor can secure for developing a new building compared with purchasing a similar, existing building. It can also be used to estimate the profit margin for a project by dividing the yield on cost by the market cap rate and subtracting 1. This would be 8.5 / 7 minus 1, or 21.4% from the above example.
Yield on Cost and Cap Rates
The yield on cost is similar to the cap rate, except that it uses the “total cost” in the denominator of the equation rather than the “market value” of a property. On the other hand, the cap rate is the ratio of NOI to the property’s market value.
Even though yield on cost and the cap rate measure two different things, these two ratios are often used together and compared to each other.
For example, a property valued at $5,000,000 with a NOI of $400,000 will have a cap rate of 8% or $400,000/5,000,000.
However, in the event that the strategy of the investor is to acquire the property and invest an additional $500,000 for renovations and improvements, expecting that the NOI can be increased to $540,000, the yield on cost then becomes 9.8% or $540,000/5,500,000.
If the market cap rate is still 8% after the value-add strategy is complete, the building’s value will be assessed at $6,750,000 or an additional $1,250,000 in value can be gained by doing the improvements.
Each investment needs to be assessed on its merits, but investors typically aim for a development spread of 150 – 250 basis points.
Some limitations of using the Yield on Cost method
YoC is based on the NOI of a property for a single year and does not consider all of the other years in the holding period and, therefore, any changes in the rental levels, vacancy rate or operating costs.
One of the best ways to address this issue is to create a multi-year proforma to gain a better, more detailed insight into what may happen to the NOI over the entire holding period.
This also enables investors to consider a range of expected outcomes to determine the best, worst, and most likely scenarios and analyse changes in a number of variables relating to both costs and revenues.
CPI Capital is well familiar with the wide range of metrics in use for the initial assessment of investment opportunities, such as yield on cost or “going in cap rate” or “development yield”. These preliminary calculations can help save a lot of time in deciding whether to pursue a particular investment opportunity or not.
However, CPI Capital understands that these are only the initial steps in investment appraisal and always prepares detailed financial pro-forma covering the expected holding period (and maybe even beyond) on any investment asset we are contemplating. We look at as many variables as possible and undertake a so-called “sensitivity analysis” to prepare a best and worst case scenario before making a final decision for our passive investors.
You can rely on us to do our homework!
CSO, COO, Co-Founder CPI Capital