Yield on cost in real estate development
Yield on cost is a development project's stabilized net operating income divided by its total development cost. A building that costs $14,848,230 to build and earns $983,520 a year once leased has a 6.62% yield on cost. Compared with the cap rate the finished building would sell at, it tells you whether building beats buying.
Updated
Yield on cost calculator
Selling costs are left out here. The full pro forma takes them off the sale and works out total cost, interest included, from your budget and loan.
The formula
Yield on cost = stabilized NOI ÷ total development cost
In the example, $983,520 ÷ $14,848,230 = 6.62%. Stabilized NOI is the income once the building is leased: rent and other income less vacancy and operating expenses. Total development cost is land, hard costs, soft costs, contingency and construction interest.
Leave out the interest and the deal looks better than it is
Construction interest is easy to forget because it never shows up on a contractor's invoice. In the example it is $918,230. Divide the same NOI by cost before interest, $13,930,000, and yield on cost becomes 7.06%: 44 bps of margin that is not there.
Yield on cost vs cap rate
Both divide NOI by a value. The cap rate uses what the market would pay for a finished building; yield on cost uses what it costs you to build one. The difference between them, often called the development spread, is the reward for the risk and the years of work. The example yields 6.62% against a 5.5% cap rate, a spread of +112 bps. Valued at that cap rate, the building is worth $17,882,182, $3,033,952 more than it cost.
How wide a spread is wide enough has no fixed answer. It depends on how much could still go wrong: entitlements, construction, lease-up, and the cap rate itself moving before you sell. Two changes to the example show how thin the margin can get:
- Rents 5% lower cut NOI to $919,224 and yield on cost to 6.19%.
- A 10% overrun on hard costs raises total cost to $15,919,818, interest included, and yield on cost falls to 6.18%.
Yield on cost and the other return measures
Yield on cost ignores time, and it sees financing only through the interest added to total cost. Two projects with the same yield on cost can have very different IRRs if one takes a year longer to build or lease up, and borrowing more moves the return on equity far more than it moves yield on cost. That is why the pro forma template reports it next to profit, levered and unlevered IRR and the equity multiple. The worked example shows all of them for the same project.
Questions
What is the yield on cost formula?
Yield on cost = stabilized net operating income ÷ total development cost. Total development cost includes land, hard costs, soft costs, contingency and construction interest.
What is the difference between yield on cost and cap rate?
Both divide NOI by a value. Yield on cost divides by what the project cost to build; the cap rate divides by what the market would pay for it. Building only makes sense when yield on cost is above the cap rate, and the gap is the developer's margin.
Is yield on cost the same as return on cost?
Usually yes. Return on cost and development yield are other names for stabilized NOI divided by total development cost, though some people use return on cost for profit divided by cost, so check which one a report means.
Should yield on cost include construction interest?
Yes. Interest is part of what the building costs. Leaving it out of this example raises yield on cost from 6.62% to 7.06%, which makes the deal look 44 bps better than it is.