Understanding Returns: Yield on Cost for the Long Term Investor

When it comes to commercial real estate investment, savvy investors have a myriad of analytical tools to evaluate asset values and future potential. Among these tools, the Yield on Cost (YOC) stands chief among them, devoid of the distortions that leverage can introduce. Especially valuable for long-term investors, YOC provides a foundation for evaluating opportunities independently of financial manipulation or projected exit values – a guiding light for investors pursuing the long-term advantages of real estate investment.

Defining Yield on Cost

Yield on Cost is simply defined as an investment’s annual net operating income (NOI) divided by the total project cost. Leverage, a double-edged sword, can magnify yields just as quickly as erode them. Yield on cost, however, disregards the impacts of leverage and provides a transparent view of the yield generated directly by the real estate and business strategy. By employing yield on cost, investors can evaluate various opportunities and determine which investments best fits their needs.

Trended vs. Untrended Yield on Cost

When assessing the yield on cost, it’s crucial to differentiate between ‘trended’ and ‘untrended’. The ‘untrended’ approach considers rental rates at their current market value, as if they were fixed. On the other hand, the ‘trended’ perspective accounts for growth potential, looking ahead to the future with the benefit of estimated and unrealized increases. While both methods have their place in a full analysis, the ‘untrended’ approach offers a conservative outlook while the ‘trended’ perspective offers a forecast into future performance. Ultimately, the choice to focus more on ‘trended’ or ‘untrended’ depends upon the individual investor’s risk tolerance and desired level of certainty.

Cap Rates or Yield on Cost?

The capitalization rate, or cap rate, and YOC are both measures of return. However, the cap rates are used as a metric to aid in the valuation of assets. Both cap rates and YOC utilize an unlevered measure of profit (net operating income); however, YOC utilizes the overall investment cost, encompassing capital allocated to renovations or enhancements, as the denominator. This aids investors in gauging the anticipated yield upon the asset’s stabilization.

Applying Yield on Cost to Investment Analysis

Below are examples to illustrate how the yield on cost metric can help compare potential returns of an investment against other market opportunities. Deciding which opportunity is more desirable will be influenced by many factors. However, if all other aspects were equal, an investor’s risk tolerance and investment objectives would play a determining role.

Scenario A may be more attractive to those investors with a higher level of risk tolerance but returns an anticipated yield higher than the alternative. It may also appeal to longer-term investors seeking high quality assets that may remain competitive within the market for years to come.

Scenario B may be more appealing to investors seeking a moderate risk profile who prefer the downside protection that acquiring an existing asset provides.

Fitting tool for the Long-Term Investor

The yield on cost metric is a key indicator of profitability, offering a vital perspective for evaluating investments in today’s dynamic capital markets. By focusing solely on the anticipated performance of the real estate and business plan, it complements essential metrics like cap rate, cash-on-cash yields, IRR, and discounted cash flow analysis, enriching an investor’s toolkit for conducting thorough financial assessments.

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Hughes Capital Partners helps clients navigate the complex world of private real estate investment. With a track record of effectively identifying risks and opportunities, we offer valuable insights to guide informed investment decisions. Our proactive, hands-on investment approach enables us to adapt to the dynamic landscape and deliver actionable strategies to help you reach your financial objectives. Connect with our team to learn more.