SS233: What Is Yield on Cost?

SS233: What Is Yield on Cost?

Yield on cost measures the risk and return profile of an investment property. In this episode, Charles discusses why yield on cost is an important metric that investors should incorporate into their underwriting.

Watch The Episode Here:

Listen To The Podcast Here:

Talking Points:

    • Yield on Cost is a key metric that we regularly use when underwriting properties, and it is sometimes referred to as the Development Yield or Return on Cost. It measures a stabilized property’s Net Operating Income divided by the Total Property Cost as a percentage.
    • For example, you purchase a property for $800,000 and invest $200,000, making the Total Property Cost $1,000,000. It generates $80,000 per year once it is stabilized. The Yield on Cost would be 8%.   
    • Most commercial real estate investors discuss cap rates as a way of gauging the value of a property versus another; however, cap rates are based on the property’s value, whereas Yield on Cost represents the property’s cost, including the purchase price and any renovations. 
    • Yield on Cost is a valuable formula for calculating the return on a property after it has been renovated and rented. It enables real estate investors to quickly calculate the viability and profitability of a deal as a percentage, allowing for easy comparison with other opportunities.
    • The main elements of this calculation include the Stabilized Net Operating Income (the NOI after the property has been completed and leased up) and the Total Property Cost (including the cost of the property, all renovation costs, and fees). 
  • How Do You Determine a Good Yield on Cost?
      • The spread you have between the market cap rate (the benchmark) and your Yield on Cost demonstrates the profitability of the deal and whether the risk and return trade-off is worthwhile. In a good growing market, I might look for a Yield on Cost of 1.5% to 2% above the cap rate. In a stagnant tertiary market, I might look for a spread of 2.5% to 3%. This spread compensates you for the risk you are taking. You will take on more risk in a tertiary market, so having a higher Yield on Cost requirement will help determine which deals are worth the risk.
      • In my previous example, where you have an 8% Yield on Cost, with a total project cost of $1,000,000, if that were in a 6.5% cap rate market, the property would now be worth $1.23 million.
    • Every metric has its limitations, and for Yield on Cost, it does not account for changes in market conditions, nor does it account for future changes in rent, expenses, or property value. However, when I examine models with underwriters going out 3, 5, or 7 years, it’s all a guess. Yield on Cost is a calculation with a much shorter timeframe.  After a property is renovated and leased, what will the Net Operating Income (NOI) be, and what will the renovation cost be? There are no refinances or sales calculations, but rather renovation costs and the projected rent for a unit over 12-24 months; refinances and sales calculations are usually wildly inaccurate anyway.
  • How Do You Adjust Yield on Cost for Future Market Conditions or Volatility?
    • You adjust for market conditions by simply adjusting the spread. If you feel there will be future volatility or you are purchasing in tertiary markets, you should consider increasing that spread.
    • This also applies in the opposite direction. If you are purchasing in a better, prime market and the property is newer, higher quality, with minimal work required, you can decrease that spread.
    • In either situation, having preset spreads correlating to risk-reward criteria will help you make better decisions. One of the best ways of using Yield on Cost is to adjust for the amount of money and time required to complete a project. Perhaps in your market, a 1-1.5% spread is sufficient for light renovations/ light value-add deals, whereas in other markets, a 2-2.5% spread is required to compensate for more substantial value-add deals. 
    • In your criteria, specify what you consider a light value-add project (perhaps under $10,000 per unit) and then describe what you consider a heavy value-add project (maybe anything over $15,000). Perhaps you will have a lower spread if this is your third deal in this neighborhood, as more immediate market experience will reduce your risk.
    • Additionally, it is not just the money invested that determines the spread, but also the time invested by you and your team to see the project through to completion and lease-up. 
    • Knowing and sticking to your criteria will help you avoid tight deals, as the spread should increase as the risk in the deal increases.
  • Adding the Yield on Cost metric to your underwriting is an excellent back-of-the-napkin calculation to utilize when determining the feasibility of a project. It is also a great way to make offers on properties, especially those that are direct to the seller, where you can adjust your offer to compensate for the risk.

Transcript:

Charles:
Most investors focus on the wrong metrics when purchasing multi-family properties, which makes the underwriting process much more difficult. And that’s why after reviewing hundreds of deals over the past decade, yield on cost has become one of my go-to checks before every investment. Welcome to Strategy Saturday, I’m Charles Carillo, and today we’re breaking down what yield on cost is, how you can use it, and why it could change the way you invest. Let’s get started. Yield on cost is a key metric that we regularly use when underwriting properties, and it is sometimes referred to as the development yield or return on cost. It measures a stabilized properties net upbringing income divided by the total properties cost as a percentage. For example, you purchase a property for $800,000. You invest $200,000, making a total property cost 1 million, it generates $80,000 per year. Once it is stabilized, the yield on cost would be 8%.

Charles:
Most commercial real estate investors discuss cap rates as a way of gauging the value of a property versus another. However, cap rates are based on the property’s value, whereas yield on cost represents the property’s total cost, including the purchase price in any renovations. Yield on cost is a valuable formula for calculating the return on a property after it has been renovated and rented. It enables real estate investors to quickly calculate the viability of profitability of a deal as a percentage allowing for easy comparison with other opportunities. Now, the main elements of this calculation include the stabilized net operating income, the NOI after the property has been completed and leased up, and the total property cost, including the cost of property, all renovation costs and fees. So how do you determine a good yield on cost? Now, the spread you have between the market cap, which is the benchmark, and your yield on cost, demonstrates your profitability in that part of the deal, and whether the risk and return trade off is worthwhile.

Charles:
In a growing market, I might look for a yield on cost of 1.5% to 2% above that cap rate. In the stagnant tertiary market, I might look for a spread of two and a half to 3% above that market cap rate. Now, the spread compensates you for the risk you are taking. You’ll take on more risk in a tertiary market. So having a yield on cost requirement will help determine which deals are worth the risk. In my previous example where you have an 8% yield on cost with a total project cost of a million dollars, if that were in a six and a half percent cap rate market, the property would now be worth $1.23 million. So you can see how valuable it is to make sure you have a spread there to compensate you for the risk and the time that you’re yield to invest to a property.

Charles:
Now, every metric has its limitations in yield on cost. It does not account for changes in marketing conditions, nor does it account for future changes in rent expenses or property value. However, when I examine models with underwriting going out three, five or seven years, it’s all a guess anyway. Yield on cost is a calculation with a much shorter timeframe because it goes out right to when it’s stabilized. It doesn’t go out many years. Like you’ll see some proformas underwriting that goes out seven years. Okay, so they’re saying, we’re gonna renovate the whole property in two to three years, and then we have these extra four year for some reason we’re doing it so we can refinance and all this kinda stuff. The yield on cost is a much shorter timeframe. After a property is renovated and leased, what will be the net operating income, the NOI and what will be the renovation cost?

Charles:
Now, there are no refinances or sales calculations, but rather renovation costs and the projected rent for a unit over say 12 to 24 months. Refinancing sales calculations are usually widely inaccurate anyway. Sometimes when I see underwriting most of the time and they are working on a lot of the returns or the IRRs getting bumped up because they’re saying we’re doing a refinancing in third year or fourth year, that really increases the return on that investment, right? The IRR. But if they didn’t have that at all, now it tells you a true story of what’s happening with the property, and this is yield on cost does that, but a very short period. So I buy the property, I renovate the property and where I am there. It’s also much easier to use current rents right now today as what the lease up rent’s gonna be in 24 months.

Charles:
It’s probably gonna be higher, but your renovation might go over too, probably will. So at the end of the day, what you have going on here is that 12 to 24 months, you’re gonna have an idea of what expenses are pretty accurately and of what rents are. It’s much more accurate than seven years out. Now, how do you adjust yield on costs for future marketing conditions or volatility? Now you adjust for marketing conditions by simply adjusting the spread. If you feel there will be future volatility where you’re purchasing in tertiary markets, you should consider increasing that spread. Now, this also applies in the opposite direction. If you’re purchasing in a better prime market in a property, in a newer, it’s higher quality. With minimal work required, you can decrease that spread in either situation. Having preset spreads correlating to risk reward criteria will help you make better decisions.

Charles:
And one of the best ways of using yield on cost to adjust for the amount of money and time required to complete a project perhaps in your market, a one to one half percent spread is sufficient for light renovations, light value ideals. Whereas in other markets, a two to 2.5% spread is required to compensate you for substantially bigger value. Add deals in your criteria, specify what you consider a light value add project, perhaps under $10,000 per unit, and then describe what you consider a heavy value add project. Maybe anything over $15,000 per unit, perhaps you’ll have a lower spread. If this is your third deal in this neighborhood, as more immediate market experience will reduce your overall investing risk. Additionally, it is not just the money invested that determines the spread, but also the time invested by you and your team to see the project through to completion.

Charles:
And knowing and sticking to your criteria will help you avoid tight deals as the spread should increase as the risk in the deal increases. Adding yield on cost metric to your underwriting is an excellent back of the napkin calculation to utilize when determining the feasibility of a project. Also gives you a great way to make offers on properties, especially those that are direct to seller, where you maybe don’t have a broker giving you some market analysis of how helpful that could be, but you’re doing it yourself so you don’t really know what to offer. Now, it’s much easier because you can work out what that is by just knowing a few different numbers from the market and where you ingest your offer to compensate for the risk that and the time that you’re gonna take on by buying the property. So I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, please check out our courses and mentor programs@syndicationsuperstars.com. That is syndication superstars.com. Look forward to two more episodes next week. See you then.

Links Mentioned In The Episode:

Are You a Fan? Subscribe, Rate, Review & Share – Click Here To Learn How

What question do you always wish I would ask but I never do?

Connect with the Global Investors Show, Charles Carillo and Harborside Partners:

Scroll to top