What is yield on cost in real estate?
Yield on cost is a development deal's stabilized net operating income (NOI) divided by its total project cost. If a project costs $20,000,000 all-in and earns $1,200,000 of NOI once stabilized, its yield on cost is 6.0%. Compare that with the market cap rate: the gap, called the development spread, is your reward for building.
The yield on cost formula in real estate
Yield on cost = stabilized NOI ÷ total project cost.
Stabilized NOI is revenue at stabilized occupancy minus operating expenses. Debt service stays out of it.
Total project cost is everything you spend to get there: land, hard costs, soft costs, contingency, and financing costs such as construction interest and loan fees. Leave the financing costs out and the yield looks better than the deal is.
How to calculate development yield on cost, step by step
- Build stabilized revenue: units × monthly rent × 12, less vacancy, plus other income.
- Subtract stabilized operating expenses to get NOI.
- Add up every use of capital, financing costs included.
- Divide NOI by total cost.
Yield on cost vs cap rate in real estate
A cap rate prices an existing, stabilized asset: NOI divided by its value or price. Yield on cost measures what you are building: NOI divided by what it costs you.
The development spread is yield on cost minus the exit cap rate. A positive spread means the finished building is worth more than it cost to deliver.
Say which rents you used. Untrended yield on cost uses today's rents; trended uses the rents you expect at stabilization. Partners will ask.
What is a good yield on cost for a development?
There isn't one number that works everywhere. It depends on cap rates in your market, the risk in the plan, and the spread you need to get paid for building. Most sponsors set their own target spread over the exit cap and pass on deals that fall short of it.
Why the cost side of development yield on cost is harder than it looks
Construction interest depends on the loan. The loan depends on total cost. Total cost includes the interest. In a spreadsheet that loop means a circular reference or an iteration setting.
In CRE Build, construction interest and fees are solved together with total cost, with no circular references. See how that works in development sources and uses.
Check your own deal's yield on cost
Run your numbers in the free feasibility model to check your deal's yield on cost. When you're ready for the full underwrite, the multifamily development pro forma starts from its own template, and multifamily acquisitions have a separate one.
Worked example (illustrative numbers, not a real deal)
Example deal with invented round numbers.
- Line
- Land
- Amount
- $3,000,000
- Line
- Hard costs
- Amount
- $13,000,000
- Line
- Soft costs
- Amount
- $2,000,000
- Line
- Contingency
- Amount
- $1,000,000
- Line
- Financing costs (interest + fees)
- Amount
- $1,000,000
- Line
- Total project cost
- Amount
- $20,000,000
- Line
- Stabilized NOI
- Amount
- $1,200,000
| Line | Amount |
|---|---|
| Land | $3,000,000 |
| Hard costs | $13,000,000 |
| Soft costs | $2,000,000 |
| Contingency | $1,000,000 |
| Financing costs (interest + fees) | $1,000,000 |
| Total project cost | $20,000,000 |
| Stabilized NOI | $1,200,000 |
- Yield on cost = $1,200,000 ÷ $20,000,000 = 6.0%
- Example exit cap rate of 5.0%, so the development spread = 6.0% − 5.0% = 100 bps
- Implied stabilized value = $1,200,000 ÷ 5.0% = $24,000,000, which is $4,000,000 over cost
- Drop the $1,000,000 of financing costs and you get $1,200,000 ÷ $19,000,000 = 6.3%. That overstates the yield by about 30 bps.
Questions
What is yield on cost?
Yield on cost is stabilized net operating income divided by total project cost. It tells you what return the finished asset earns on everything you spent to build or reposition it.
How do you calculate yield on cost?
Divide stabilized NOI by total project cost. For example, $1,200,000 of NOI on a $20,000,000 project is a 6.0% yield on cost.
What is the difference between yield on cost and cap rate?
Yield on cost divides NOI by what the project costs; cap rate divides NOI by what a stabilized asset is worth or sells for. The gap between the two is the development spread.
What is a good yield on cost?
A good yield on cost beats the market cap rate by enough to pay for the risk of building. Many sponsors set a target spread over the exit cap and treat anything below it as a no-go.
Should financing costs be in total project cost?
Yes. Construction interest and loan fees are real costs of the project; leaving them out makes the yield look higher than it is.
Check your deal's yield on cost
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