One of the most fundamental concepts in commercial real estate (CRE) investment is understanding the relationship between risk and return. The more risk a commercial property carries, the greater the potential reward. However, risk can be tricky to quantify because it is all relative. Each investment and each CRE property type carry their own levels of risk, and it is up to investors to identify where the risk lies and to determine if the potential return is worth it. One of the ways that value-add investors do this is to utilize a metric called Yield on Cost.
The yield on cost formula is calculated as net operating income divided by total project cost.
In order to understand yield on cost in commercial real estate and why it is important, it is first necessary to review the value-add investment strategy. In this article, we will provide an overview of the value-add investment strategy, define yield on cost with examples, and compare yield on cost to the cap rate.
FNRP’s value-add strategy is focused on finding risk-adjusted returns for our investors. To learn more about the commercial real estate investments we offer, click here.
Overview of the Value-Add Investment Strategy
Value-add investors seek to acquire properties at a discount to their replacement cost, and to improve them through renovations, new tenants, lease extensions, cost efficiencies, and rebranding. The desired result of these activities is improved Net Operating Income, which also improves the market value of the asset.
But there is ample risk in a value-add approach:
- construction risk
- leasing risk
- execution risk
- management risk
In order to justify taking this type of risk, we must be compensated for it. For example, we could buy an existing retail shopping center that doesn’t need any renovations or leasing help. There is less risk in this approach, but we would also have to pay more, which lowers overall returns. This is where yield on cost comes into play.
Yield on Cost Definition
Yield on cost is a real estate financial metric that helps investors quantify the risk taken to purchase an asset. The yield on cost formula is calculated as a property’s stabilized Net Operating Income (NOI) divided by the total project cost. As value-add investors, yield on cost is a useful metric for two reasons:
- It provides a way to compare the potential return on a value-add investment versus less risky alternatives.
- It is an easy, back-of-the-envelope way to calculate expected commercial real estate returns. As such, it can be a quick way to filter out deals that don’t meet our return criteria.
Yield on Cost Example with 3 Options
The logic behind the use of yield on cost in real estate can be illustrated with a simple example. Assume that an individual has $1,000,000 to invest and they are trying to decide between three different options.
Option 1: 10-Year Treasury
The first option is the 10-Year Treasury. At the time of writing, the interest rate is 1.55%. This represents the rate of return that can be achieved without taking any risk, and it acts as a reference point against which to evaluate other, riskier alternatives.
Option 2: Stabilized Option
The second option is the stabilized option. It is a Class A shopping center with a prime, high-traffic location. This is a stabilized property that has a purchase price of $1,000,000 and net operating income of $50,000. As such, the yield on cost is 5.00% ($50,000 / $1,000,000).
Option 3: Value-Add Option
The third option is the value-add option. It is a similarly sized retail shopping center in a slightly less desirable location. It has some vacancy and needs some repairs. It has a cost of $750,000, but the required renovations and marketing expenses needed to get the property fully leased are estimated to be $250,000. Based on the pro forma, this property could produce $75,000 in Net Operating Income at stabilization. As such, the yield on cost is calculated to be 7.50% ($75,000 / $1,000,000)
Choosing the Right Yield on Cost
Of the three options, the Treasury is the least risky, but it also offers the lowest potential return. The difference, or the “spread,” between the two property options is 2.5%, which leaves the real estate investor with one important question to answer: does the opportunity to earn an extra 2.5% in yield justify the additional risk that must be taken to purchase the value-add option?
Yield on Cost vs. Capitalization Rate
Both yield on cost and the cap rate offer insight into the potential return on an investment property, but there is one key difference.
Cap rate in real estate is the return that an investor could expect to earn on an all-cash purchase of a stabilized property—or another way to think about it is as the yield before any sort of net operating income growth. The cap rate can differ by market, property type, and asset class, but the general idea is that it should be the same between two similar, stabilized properties.
In a value-add investment, the intent of the investment strategy is to improve the property value through various actions meant to increase net operating income. The “cost” in the calculation includes the purchase price and the cost of property renovations. So, it is meant to capture the growth achieved as a result of the property improvements.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.