In this article:
- What is Yield on Cost?
- How to Calculate Yield on Cost
- Yield on Cost vs. Cap Rate
- Practical Examples of Yield on Cost
- Using Yield on Cost to Make Investment Decisions
- Conclusion
What is Yield on Cost?
Yield on cost, also known as development yield or return on cost, is a critical metric in real estate development that measures the return on an investment based on its total cost and projected net operating income (NOI). This metric allows investors to assess whether a project’s potential returns justify the associated risks and costs.
How to Calculate Yield on Cost
The formula for yield on cost is straightforward:
To calculate yield on cost:
- Determine the Net Operating Income (NOI) of the project.
- Divide the NOI by the total project cost.
Example Calculation
If a project has a net operating income of $2,000,000 and the total project cost is $25,000,000, the yield on cost would be:
Yield on Cost vs. Cap Rate
While both yield on cost and cap rate are used to evaluate real estate investments, they serve different purposes and provide different insights.
- Cap Rate: Reflects the return on an investment based on its current market value. It’s a snapshot of the property’s performance at a given point in time, influenced by broader market conditions.
- Yield on Cost: Focuses on the return relative to the total development cost, providing a forward-looking measure that helps investors understand the potential profitability of a new project.
Practical Examples of Yield on Cost
To illustrate the application of yield on cost, consider the following two development projects:
Example Projects:
| Deal 1 | Deal 2 | |
| Net Operating Income | $2,100,000 | $1,620,000 |
| Total Project Cost | $29,600,000 | $18,900,000 |
| Yield on Cost | 7.1% | 8.5% |
Analysis
- Deal 1: Despite a higher NOI, the substantial project cost results in a lower yield on cost (7.1%).
- Deal 2: With a more modest NOI but lower project costs, Deal 2 achieves a higher yield on cost (8.5%).
In this scenario, Deal 2 appears more lucrative based on yield on cost alone. However, investors should also consider other risk factors and perform comprehensive market analysis.
Using Yield on Cost to Make Investment Decisions
Yield on cost is an invaluable tool for comparing the profitability of different real estate projects. By benchmarking yields against market standards, investors can make informed decisions on where to allocate their capital. It’s important to note that this metric should be used in conjunction with other financial and risk assessments to provide a holistic view of a project’s potential.
Leveraging Technology
Modern deal management platforms can significantly enhance the process of calculating and analyzing yield on cost. These platforms centralize data, streamline workflows, and provide powerful analytics, enabling investors to make more informed, data-driven decisions.
Conclusion
Yield on cost is a fundamental metric for real estate developers and investors, offering a clear view of the potential return on a project’s total investment. By understanding and applying this metric, investors can better gauge risk, compare opportunities, and strategically manage their portfolios.
About the Author
Timothy Shaw
Timothy Shaw is a Founding Partner at The Stream Group. Leveraging his broad experience in real estate, he provides strategic guidance and advisory support. His background includes multifamily syndications, distressed asset acquisition, and serving as a licensed real estate salesperson in Ohio. At The Stream Group, Tim focuses on ownership and investment strategies, ensuring the firm’s long-term growth and vision.
Before his real estate career, Tim served as a lieutenant in the fire department. His career in public safety allowed him the opportunity to serve in many roles, including firefighter, flight paramedic, hazardous materials technician, and certified fire safety inspector. This background instilled a deep commitment to service and integrity, values he brings to his work with investors, tenants, and team members.
A graduate of the University of Cincinnati with a degree in Fire Science Engineering, Tim is dedicated to creating an environment where systems and data drive success. He admires Warren Buffett’s investment philosophy: “When others are greedy be scared, when others are scared be greedy.”
Tim is married with two children and enjoys traveling with his wife. They spend their free time at their second home on Amelia Island.