Yield on Cost: Underrated Financial Metric

When underwriting a multifamily property, I'm less concerned about cap rates and more interested in this metric - Yield on Cost.

Yield on cost is an underrated financial metric that can give great insights into a commercial real estate investment.

To verify that the risk incurred is worth the return on investment, investors often calculate the yield on cost.

What is Yield on Cost?

You've probably heard of yield on cost (YOC) before but let's break down exactly what it means. It's somewhat of a mix between a cap rate and cash-on-cash return.

Yield on cost is the net operating income (NOI) at stabilization divided by the total project cost. The capitalization rate (cap rate) is the NOI divided by the purchase price (or market value).

Yield on Cost is often used interchangeably with Return on Cost (ROC), Development Yield, and Net Yield.

Yield on Cost= Net Operating Income/Total Project Cost

Tip: The stabilized NOI is often used in this calculation, but I still like to view this on an annual basis. The project cost will include your CapEx amount, purchase price, and any other costs associated with the deal.

Add this calculation to your underwriting model if it's not there already.

The Problem with Relying on Cap Rates:

Cap rates look at how quickly you are earning back your investment on an unlevered basis.

The cap rate formula is misleading because it doesn’t account for the CapEx amount. CapEx or capital expenditures is the cost for the needed improvements to the property.

While an investment may look like a reasonable cap rate (high) at the surface level, if other comparable properties trade around the same cap rate but don’t need a significant CapEx budget, the property may be overvalued.

Simply put, if you know you are buying a property that needs a significant amount of work completed, you will want to buy at a price that makes sense.

For investors reviewing multiple deals, examining the yield on cost across deals in the same location or asset class can add much-needed context. Reviewing these metrics across deals takes can paint a more comprehensive picture of the ROI.

Investment strategies vary considerably, so some investors may favor low-risk projects with relatively low yield-on-cost, while other high-risk investors may only pursue projects with high development yields.

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Why are these renters able to keep paying higher rents at essentially normal levels? 

Class A and B renter households have seen incomes rise nearly as fast as rent (among new lease signers). A typical Class A renter household (including roommates) now has annual income of $135,000, while a typical Class B renter household is $99,600.

Household incomes in Class C have grown, but annual wages remain lower at $62,000. While Class C in-place rents grew a lesser 10% since March 2020, we’ve seen a bit more distress in this group. Class C rent collections were lower than Class A and B pre-COVID.

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