Yield on Cost (YoC) is a crucial metric in real estate investing that assesses the potential return of a property development project against its total cost. By calculating YoC, investors can determine if the expected return on investment justifies the expenses incurred during development.
How to Calculate Yield on Cost (YoC)?
The formula to calculate YoC is simple. It involves dividing the property's stabilized net operating income (NOI) by the total cost of development. The stabilized NOI represents the expected annual income once construction and developmental work are complete, while the total cost includes the purchase price and development expenses.
To calculate YoC, use the following formula:
Yield on Cost (YoC) = Stabilized NOI ÷ Total Cost
The potential return is expressed as the YoC percentage, ensuring that the expected return on investment exceeds the total cost incurred.
Yield on Cost vs. Cap Rate: What is the Difference?
While analyzing property investments, investors often encounter two common metrics: the capitalization rate (cap rate) and the yield on cost (YoC).
- Capitalization Rate: Cap rate is the ratio between the net operating income (NOI) and the fair market value (FMV) of a property. It offers insights into the current value of a property.
- Yield on Cost (YoC): YoC is the ratio between the NOI and the total development cost. It assesses the return on investment during the development phase.
The key distinction lies in the denominator of the formulas. Cap rate utilizes the FMV, while YoC considers the total cost of development. Consequently, YoC can be interpreted as a forward-looking cap rate.
What is a Good Yield on Cost?
Typically, real estate investors perceive a higher YoC more positively. However, it is essential to compare the yield of the target property with that of comparable properties in the market.
Commercial real estate relies on YoC as a quick "back-of-the-envelope" method to determine if the risk/return trade-off on a potential property development investment is worthwhile. If the return on a development project does not surpass that of acquisition projects, most rational developers would forego the opportunity.
The potential property development investment must compensate for the time commitment, resources, and initial outlay. On the other hand, acquisition projects generate steady income streams from tenants in the long term.
Yield on Cost Calculator (YoC)
To better understand YoC, let's consider a modeling exercise. Suppose a commercial real estate investor is evaluating an opportunity to purchase and develop a rental property. The total cost of the project, including the purchase price and development costs, amounts to $40 million.
- Total Cost: $40 million
- Effective Gross Income (EGI): $5 million
- Total Operating Expense: $2.6 million
- Stabilized Net Operating Income (NOI): $2.4 million
Using these figures, we can calculate the YoC:
Yield on Cost (YoC) = $2.4 million ÷ $40 million ≈ 6.0%
Ultimately, a real estate investor's decision on a property development investment depends on how the YoC compares to similar opportunities in terms of risk and returns.
Remember, YoC is just one factor in real estate investment analysis. Cap rate, development spread, and external market considerations also come into play.
