Understanding Yield on Cost (YoC)

Calculating the Yield on Cost (YoC)

The yield on cost (YoC) is a critical metric used in real estate investing to determine if the potential return justifies the cost of developing a property. Unlike the cap rate, which compares net operating income (NOI) to the fair market value (FMV) of the property, the YoC compares NOI to the total development cost. This forward-looking metric helps investors assess the risk and potential reward of a project before construction begins.

To calculate the YoC, divide the stabilized NOI by the total development cost. The stabilized NOI refers to the expected annual income once the property is fully functional and operating, while the total cost includes both the purchase price and the cost of developing the property. For example:

Yield on Cost (YoC) = Stabilized NOI / Total Cost

Yield on Cost vs. Cap Rate: Understanding the Difference

While there are various return metrics in real estate investing, the YoC and cap rate are two commonly used metrics. The cap rate compares NOI to the FMV, while the YoC compares NOI to the total development cost. The YoC can be seen as a forward-looking cap rate.

Although both metrics are pro forma measurements, the YoC carries more uncertainty and risk since the property's NOI must be stabilized, and construction work has not yet started. To assess a potential real estate investment effectively, investors can also analyze the development spread, which compares the YoC (going-in cap rate) to the market cap rate (going-out cap rate).

What Constitutes a Good Yield on Cost?

A higher yield on cost is generally perceived more positively by real estate investors. However, it is essential to compare the yield of a property to that of comparable properties in the market. The commercial real estate market often relies on the YoC as a quick way to assess the risk and return trade-off of a potential property development investment.

For development projects, which start from scratch and require significant investment, the returns must justify the time commitment, resources, and initial outlay. On the other hand, acquisition projects involve purchasing existing properties and focusing on maintenance and renovation costs to stabilize and improve the property's profitability.

Yield on Cost Formula (YoC)

The YoC is calculated by dividing the stabilized NOI by the total cost of the property. The stabilized NOI represents the expected annual income once the property is fully functional, while the total cost includes the purchase price and development costs.

Yield on Cost (YoC) = Stabilized NOI / Total Cost

Yield on Cost Calculator (YoC)

To illustrate the calculation, let's consider a hypothetical scenario:

Suppose a commercial real estate investor is considering purchasing land for a rental property development. The total cost of the project, including the purchase price and development costs, amounts to $40 million. After analyzing the potential future rental income, the projected effective gross income (EGI) at stabilization is $5 million, and total operating expenses are $2.6 million. Consequently, the stabilized NOI is $2.4 million.

Using these inputs, we can calculate the YoC:

Yield on Cost (YoC) = $2.4 million ÷ $40 million = 6.0%

The 6.0% YoC serves as a crucial factor in the investor's decision-making process, signaling whether the potential returns outweigh the total cost and associated risks.

Remember, the YoC is only one among many factors that investors consider, such as the cap rate, development spread, and market conditions.