Yield on cost
Also called YOC, Development yield, Return on cost.
Yield on cost is stabilised net operating income divided by total project cost, including land, hard costs, soft costs, financing costs and carry. It is the development and value-add equivalent of a cap rate, and the spread between it and the market cap rate is where the profit comes from.
How it works
For a stabilised acquisition, price and cost are the same thing and a cap rate answers the question. For anything being built, renovated or leased up, they are not: total cost includes construction, fees, interest carried during the build and the losses absorbed during lease-up. Yield on cost is the measure that captures all of it.
The number practitioners actually watch is the spread, sometimes called the development spread or the profit margin on cost. A project yielding 7.0 percent on cost in a market that values stabilised assets at a 5.75 percent cap has 125 basis points of spread, and that spread is the compensation for construction risk, lease-up risk and time. Typical hurdles run 100 to 200 basis points depending on asset class and how much of the cost is already sunk, though these are conventions rather than rules.
Because the spread is a difference between two small numbers, it is unstable. A 50 basis point cost overrun and 25 basis points of cap rate expansion can remove most of a 125 basis point spread between them, which is why development underwriting always carries a contingency and always runs the exit cap as a sensitivity rather than a point estimate.
Formula
Yield on cost = stabilised NOI / total project cost- Total project cost includes land, hard costs, soft costs, developer fee, financing costs and interest carry
- Stabilised NOI is the first full year at stabilised occupancy, not the first year of operations
- Development spread = yield on cost - market exit cap rate
Worked example
Illustrative ground-up project. Market exit cap rate 5.75 percent.
| Total project cost | $48,000,000 |
|---|---|
| Stabilised NOI | $3,360,000 |
| Yield on cost | 7.00% |
| Development spread | 125 basis points |
| Stabilised value at a 5.75% cap | $58,434,783 |
| Development profit and margin | $10,434,783, a 21.7% margin on cost |
The entire $10.4 million of profit is created by the 125 basis point spread. Lose 60 basis points of it to cost overruns and cap rate expansion and roughly half the profit goes with it.
The common mistake
Leaving interest carry and lease-up losses out of cost
Total project cost is not the construction budget. Interest accruing during the build, loan fees, the developer fee and the operating losses absorbed between certificate of occupancy and stabilisation are all cost, and on a longer project they can add 10 to 15 percent. Omitting them inflates yield on cost by 50 to 100 basis points, which on a 125 basis point spread is most of the deal. If the yield on cost is computed off the hard cost budget, it is not a yield on cost.
Related terms
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
- Going-in versus exit cap rateThe going-in cap rate is year-one NOI divided by the purchase price. The exit or terminal cap rate is the rate applied to the forward NOI at the end of the hold to estimate the sale price. The spread between them is one of the largest and least evidenced assumptions in any underwriting.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Loan to costLoan to cost is the loan amount divided by total project cost. It is the leverage constraint used on construction and heavy value-add loans, where the property has no stabilised value to lend against and cost is the only verifiable basis.
- Internal rate of returnThe internal rate of return is the discount rate at which the net present value of a deal's cash flows equals zero. It expresses a full investment, including the timing of every contribution and distribution, as a single annualised percentage.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.