To verify that the risk incurred is worth the return on investment, investors often calculate the yield on cost. Also known as development yield, this crucial metric for real estate investors helps them make this determination as part of the deal analysis. This metric is one way to avoid the costly mistake of pursuing a deal with returns that won’t align with your investment strategy. Read on to learn more about yield on cost in real estate, including how to calculate it, what it means, and more.
What is Yield on Cost in CRE Development?
Yield on cost, or development yield, is a benchmark that investors utilize to assess a project based on its cost and potential return. To calculate it simply divide the net operating income by the project’s total cost.
Yield on Cost Commercial Real Estate Formula
Yield on Cost= Net Operating Income/Total Project Cost
One primary goal for investors during deal analysis is determining if the potential ROI is worth the cost. The development yield offers one way to answer this question. While a good yield on cost will always be higher, this metric is best used comparatively. By calculating a deal’s development yield and comparing it to others, you can quickly look at them side by side, then choose to reject or prioritize them.
Yield on Cost Vs Cap Rate
A property’s cap rate and development yield are both critical financial metrics, but provide different information about a deal.
The cap rate of a property takes its present value into account, creating a benchmark for its value at a certain moment in time. This also changes over time, meaning the cap rate won’t be static.
Example: Yield on Cost in Practice
To better understand how to calculate and leverage the yield on cost, let’s look at two new pipeline deals. For the purposes of this example, assume that we know the deals’ net operating incomes and total project costs.
|Deal 1||Deal 2||Historical deal 1||Historical deal 2|
|Net operating income||$2,104,000||$1,620,000||$1,750,000||$1,830,000|
|Total project cost||$29,600,000||$18,900,000||$22,700,000||$25,300,000|
While the first new deal has a high net operating income at $2.1 million, the relatively high total project cost brings the yield on cost below the 7.2-7.7% benchmark in this sub-market at 7.1%. The second deal, on the other hand, is well above this historical benchmark at 8.5%.
Based on this information, it appears that, of these two deals, deal 2 may be more lucrative. To fully assess if this deal fits the target profile, though, an investor would likely measure risk in other ways, including a deeper dive into sub-market historicals.
How Do Investors Use Development Yield to Vet Deals & Make Decisions?
For investors reviewing multiple deals, or comparing new deals against historicals, 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 them out of a vacuum, painting a more comprehensive picture of the ROI. Because investment strategies vary considerably, 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.
Deal management platforms help investors to fully leverage historical investment data to unlock competitive insights. Beyond centralizing this competitive information in one platform, deal management software like Dealpath helps investors to intuitively reference these deals by using smart filters and search functionality. Instead of digging through shared spreadsheets, investors have access to boundless deal data at their fingertips. As a result, investors can quickly and easily make the appropriate comparisons for informed, fully vetted decisions.
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Tracking pipeline deals in a dedicated deal management platform ensures that every deal you review is preserved for future comparison on relevant deals. To learn more about why it’s time for a deal management platform, download our e-book.