Yield on Cost vs Cap Rate

[Jaden George]

The most fundamental metric in the commercial real estate space is, without a doubt, the capitalization rate or cap rate. It is calculated by dividing a property's net operating income (NOI) by the purchase price (NOI ÷ purchase price). There are a variety of uses for cap rates, including gauging market appetite for a particular asset, evaluating a deal at a specific purchase price, and estimating a future exit price. Here I will focus on evaluating and comparing deals.

I argue that cap rate as a return metric fails to tell us the entire story. In fact, it tells us very little about the asset and its potential. This becomes more and more true the further the asset is from a stabilized state (e.g., the heavier the value-add). Take a 100-unit property with current average rents at $1000/mo. running at a 50% expense ratio (operating expenses equal 50% of income). This property generates $600,000 in net operating income ([$1,000 x 100 x 12] x 0.5). If the asking price for this property were $12,000,000, the cap going-in cap rate would be 5% ($600,000 ÷ $12,000,000). If the going market cap rate for assets like this one is 6%, then this asset seems way overpriced on the surface. But what if you learn that the property is experiencing a very high loss to lease (LTL), meaning their leases are severely under market rates? Similar units in the area are renting for $1,300/mo. and the subject property will only require about $1,000/unit in capital expenditures to compete with comparable properties. In addition, we also learn that the property has been run very inefficiently, and new ownership will have no problem running this particular asset at a 40% expense ratio. This is where the cap rate leaves us high and dry, and yield on cost comes in to give us a way to evaluate and fairly compare this value-add opportunity to others.

The yield on cost (YOC) is calculated by dividing stabilized NOI by total project costs (stabilized NOI ÷ total project cost). Here, the denominator will include purchase price, capital expenditures, sponsor fees, and acquisition/financing costs. Assuming $500,000 for closing costs, this investment's YOC would be 7.4%. This number is much more helpful when comparing two investment opportunities as it tells a much fuller story than the cap rate. This is because it includes the stabilized performance of the property and the costs associated with executing the business plan. In contrast, the cap rate considers the current NOI and purchase price alone.

Taking it a step further, we can calculate something called a development spread. A development spread is the difference between the YOC and the market cap rate. It quantifies the value the business plan will add to the asset in the current market context. In our example above, the opportunity provides a 1.4% development spread (7.4% - 6%). Further, dividing the development spread by the market cap rate gives us the development lift, which indicates the value added as a percentage of the market cap rate. The example above shows a 23.3% development lift (1.4% ÷ 6%). This metric is helpful when comparing two opportunities in different markets or across asset classes (or any situation where market cap rates vary between assets).

While the cap rate certainly has its utility, I hope you can see that YOC and development lift tell a much more valuable story when evaluating and comparing two or more value-add opportunities.