Commercial property development, acquisition of the property, and operating expenses add up and make the viability of an investment opaque.
Explore what yield on cost in commercial real estate is with Christina, so you know exactly what to expect out of your investment.
What Is Yield On Cost?
Yield on cost is a financial metric used to determine a capital asset’s ability to overcome
its costs and produce a worthwhile return. For many high-value investment projects, steep financial thresholds can make an investment far riskier. If the asset doesn’t make a strong enough return over a certain period of time, investors may be stuck with an investment that isn’t worth the money.
Yield on cost helps investors assess the effectiveness of an asset that will recuperate from its initial and long-term risks. Generally speaking, yield on cost — or development yield — is used before an asset is procured or developed in order to determine if its returns fit within the investor’s strategy.
This metric is used on a wide range of investment types. In the case of high-value assets, like commercial real estate, it’s an essential part of determining whether the investment is a wise one or not.
What Is Commercial Real Estate?
Real estate is a distinctive asset class. Property has unique benefits that set it apart from conventional assets, like stocks and bonds. Even within real estate, there are specific property types that have a range of differences from one another.
Commercial real estate refers to property types that are specifically used for conducting a profit. Whether that profit comes from capital gains or rental income depends on the business type.
Commercial properties may include:
- Restaurants
- Office spaces
- Apartment buildings
- Retail buildings
- Industrial spaces
- Grocery stores
- Medical facilities
What Is Yield On Cost in Commercial Real Estate?
Within the specific context of commercial real estate, yield on cost may refer to the ability of a property to generate a return in relation to its high costs. Yield on cost could be used on a number of commercial real estate projects.
From the development stage to value-add investments like renovations of already built properties, calculating a commercial real estate asset’s yield on cost crunches all the costs of the project into a simple metric; that metric can let investors know if they should go forward with the project or not.
What Is the Formula Yield On Cost?
Finding a commercial real estate project’s yield on cost comes down to applying this simple formula: net operating income divided by total project cost. In order to establish a project’s yield on cost, investors must first find these other two factors.
- Net operating income
- Total project costs
Net Operating Income
A commercial property’s net operating income measures the total balance between an asset’s income stream subtracted by all outgoing expenses. Net operating income, NOI, is a fundamental financial metric. It measures the balance of ingoing and outgoing expenses within a given time frame.
Establishing a commercial real estate project’s net operating income tells investors how much income it can be expected to generate in a certain period of time. When a project’s income exceeds its outgoing expenses, investors can be more confident about the asset’s ability to sustain a return.
In the case of commercial properties, the income generated by the property is most likely to come from rental income paid by the tenant. Operating expenses may refer to property taxes, loan payments, mortgage interest, insurance payments, maintenance, and utilities. The balance tells investors if rental income is enough to exceed these operating expenses.
Total Project Costs
The total costs of a commercial real estate project refer to the grand total of expenses that have gone into it. Total costs of a commercial real estate project may refer to a wider range of expenses than those that determine net operating income; that’s because net operating income looks present as outgoing expenses. Total project costs factor in a more complete vision of a commercial project’s expenses.
What expenses total project costs include may vary depending on the commercial real estate project’s stage of development. A project early in the development stage may include construction costs, labor, and so on. These early-stage costs will have a deep influence on the project’s total price tag.
Investors interested in acquiring already developed projects should still account for outsized total project costs. Commercial real estate assets are extremely high value; their purchase price alone is not the only factor that investors need to pay for. Investors should account for the legal fees, inspection costs, finders fees, and many more expenses beyond the purchase price.
What Does Yield On Cost Tell You?
Simply put, yield on cost tells investors what to expect out of a commercial real estate project and its ability to take them into the green. Together, the net operating income and total project costs form the means by which a commercial real estate project can offset costs.
Because yield on cost tells investors what they should expect from an asset’s ability to recoup its costs, these two factors paint the clearest picture of how a commercial real estate project actually accomplishes that.
Net operating income tells investors how effectively the property’s operations produce an income. The total project costs give investors the complete price tag of what they need to pay off in order to emerge from the red. The yield on cost formula identifies the level of sustained net operating income a project generated to reduce the total project costs over time.
Examples of Yield On Cost
To demonstrate how the yield on cost helps investors make better decisions, consider these two speculative examples.
Property A has a net operating income of two million dollars a year. Its total project costs are 30 million dollars. Property B has a net operating income of only 1.5 million dollars, but total project costs amount to 20 million dollars.
While Property A has a higher net operating income than Property B, it has a less favorable yield on cost rate. The yield-on-cost rate for Property A is 66 percent (two million divided by thirty million equals .06667), whereas Property B has a yield-on-cost rate of 75 percent.
A superficial glance at these two properties may encourage investors to opt for Property A; it has a much higher net operating income than Property B. However, the significantly higher total project costs of Property A means that its yield on cost will not take the investor out of the red before Property B. Investors that choose Property B can expect to earn their return faster, even though the net operating income isn’t as strong.
Utilizing Yield On Cost In Your Investment Strategy
Financial metrics like yield on cost are an integral part of an effective, well-informed investment strategy. Utilizing yield on cost will have a dramatic impact on how investors choose their investments.
Let’s go over the benefits and limitations of making investment decisions with yield on cost.
The Benefits
- Better perspective
- Measures performance over time
Better Perspective
Yield on cost gives better context on a potential investment. The financial viability of an investment is more than just the income it produces. Yield on cost accounts for a bigger picture of an investment, one that helps investors choose assets that may help them start earning a return faster.
When investors assess the value of their return in a larger, cost-related context, they gain a better perspective on the asset’s ability to earn a return.
Measures Performance Over Time
Investors gain a deeper insight into an asset’s performance with yield on cost. An investment that recoups on the total costs of a project faster may be a better one for most investors.
By factoring in an asset’s net operating income, yield on cost is able to demonstrate an asset’s ability to progress over time; at the current yield on cost rate, investors can expect to recuperate on costs within a specific time span.
The Limitations
- Subject to change
- Doesn’t tell the whole story
Subject To Change
Yield on cost gives investors a strong idea about what kind of performance to expect out of their project, but it is never a certainty. At the end of the day, yield of cost measurements are always subject to change.
The results gleaned through this metric are speculative. Because the net operating income estimates a year’s long performance, investors can never be sure those numbers will remain the same. It’s important for investors to remember that yield on cost may very well change over time. It only predicts an assumed yield on cost within a year’s time, and even within the year, those predictions are never certain.
Doesn’t Tell the Whole Story
Yield on cost is a specific metric for a specific goal. Investors ought to utilize the full breadth of financial metrics available to them when putting together a cohesive investment strategy. Yield on cost may be a useful metric to assess the potential of a commercial real estate project, but it is not the only one investors need to use.
Overreliance on a single metric, like yield on cost, can result in an investment strategy that lacks the dimension to be truly successful. Including a wider range of metrics can help you make better decisions.
What Other Financial Metrics Should You Use?
Utilizing a wide range of financial metrics beyond yield on cost opens up a new realm of possibilities. The more information you get about a potential investment, the better equipped you are to make a final decision.
Here are a few other financial metrics you should consider when making your next real estate investment:
- Return on investment
- Internal rate of return
- Earnings before interest and taxes
- Capitalization rate
Return On Investment
Return on investment is one of the most straightforward financial metrics investors can use. It measures the ratio of net income produced by an asset.
ROI determines the asset’s ability to earn gains for investors or not. Unlike yield of cost, ROI is calculated in hindsight. Investors utilize realized gains or losses to assess the efficiency of an asset’s growth.
ROI is a solid metric to use when assessing an asset’s history thus far. However, it has little speculative insight as to how an asset will do other than its past history. Investors should consider other financial metrics if they are interested in an asset’s potential future performances instead of ROI.
Internal Rate of Return
Internal rate of return is used to predict the rate at which an asset earns a return. IRR is calculated to determine the rate at which an asset will reach its net present value. In other words, investors can find out an asset’s rate of expected growth.
Like YOC, IRR is speculative; information collected in the present is used to project the future potential of an asset. As such, it is never a certainty that the predicted IRR will be realized. Nevertheless, it is an extremely useful metric to assess the long-term potential of an asset. A strong IRR is a compelling feature in an investment property.
Earnings Before Interest, Taxes, Depreciation, and Amortization
EBITDA is a helpful formula that helps investors see the unadulterated revenue generated by an investment property. Investors will inevitably have to pay extraneous expenses on their investment property, mortgage interest, and property taxes, to name a few. EBITDA, or operating income, excludes these operating expenses involved in a property’s cash flow.
Calculating the income generated by a property before expenses are considered gives investors a clearer idea of what that asset is capable of. EBITDA isolates the revenue their asset produces. The insights provided by EBITDA let investors know how well their assets are performing on their own terms.
Capitalization Rate
Capitalization rate is a financial metric with a specific focus on income-earning commercial properties. Cap rate measures the rate at which an investment property will earn back its purchase price by dividing its net operating income by the asset’s value.
It is very similar to yield on cost, with a key difference: capitalization rate utilizes a property’s present market value, whereas yield on cost factors in the total project costs.
The difference between cap rate and YOC means that cap rate won’t have the same static output that YOC has. The present market value of a property is bound to change over time.
While factors in YOC are subject to change as well, they provide a slightly more solid projection than cap rate does. Nevertheless, both are crucial financial metrics that investors should consider when investing in commercial real estate.
What Are the Advantages of Commercial Real Estate?
There are plenty of ways to assess the viability of a commercial real estate project. Choosing a better investment property means that investors are more likely to reap the benefits of commercial real estate ownership.
Here are a few key advantages of owning commercial investment properties:
- High cash flow
- Businesses are reliable tenants
- Tax benefits
High Cash Flow
Real estate assets are well-known for their high cash flow; commercial real estate assets even more so. Cash flow measures the ingoing and outgoing cash of a capital asset or company. Positive cash flow indicates that there is more cash being generated by an asset than what goes into it.
Real estate has strong, positive cash flow because annual rent needs to bring in more cash than its operating expenses through its rental agreements. Leases give property owners a cash flow advantage because they can reliably set the level of monthly rent they need in order to sustain positive cash flow levels.
Businesses Are Reliable Tenants
Residential and commercial properties are often utilized as rental properties. Commercial properties have a distinct advantage over their residential counterparts because businesses tend to be better, more reliable tenants.
Businesses operate in order to generate capital gains. The reason why a business leases a commercial space is to better accomplish its goal of earning a profit. Because their goals are aligned with the property owners — earn a profit — commercial property owners can be expected to consistently and higher market rent from their tenants.
Tax Breaks
Real estate investing presents many tax write-off opportunities for investors. Operating expenses that would otherwise contribute to total project costs may, in fact, be tax deductible. Renovations and maintenance projects to maintain a property from wear and tear can be written off at the end of the year.
Furthermore, depreciation gives property owners a tax deduction stipend every year of a property’s life — 39 years for commercial properties.
Utilizing the tax break opportunities makes real estate all the more lucrative. Tax-based incentives allow property owners to take home more of their NOI, which allows for a greater opportunity to make better, higher-earning investment decisions.
Invest With the Experts
Knowing the financial metrics that drive better financial decisions is the first step toward building a stronger portfolio. But with so much to know about the complexities of smart real estate investing, investors can benefit greatly by turning to the professionals.
For over 40 years, Christina has thrived in the most competitive real estate market in the United States — the Westside region of Los Angeles. Our team has the skill set and the knowledge to best implement financial metrics like yield on cost so that investors get the best possible return.
Get started with us today and get a better return tomorrow.
Sources:
Return on Investment (ROI): How to Calculate It and What It Means | Investopedia
Publication 946 (2021), How To Depreciate Property | IRS
capital gains | Wex | US Law | LII / Legal Information Institute
Capitalization Rate: Cap Rate Defined With Formula and Examples | Investopedia.