Yield on Cost (YOC) Explained
Yield on Cost (YOC) is a financial metric commonly used in real estate development to measure a property development project’s return on investment (ROI). It is calculated by dividing the annual net operating income (NOI) of the property by the total cost of the project.
For example, if a property has an NOI of $500,000 per year and the total development cost is $5,000,000, then the YOC would be 10%.
Untrended vs. Trended YOC in Real Estate
The calculation for trended YOC involves adjusting the rent return of the property to either a projected market rate or current but unrealized market rate.
For example, if a property costs $10,000,000 to develop and would currently generate an annual NOI of $600,000, the untrended YOC would be calculated as $600,000 / $10,0000,000 = 6.00%.
If there is expected to be 5% growth per year to NOI before the property is built and stabilized, which is expected to take three years, then trended YOC would utilize the projected NOI of $694,575. In this situation, the trended YOC would be calculated as $694,575 / $10,000,000 = 6.95%
Trended YOC Offers Better Accuracy
Trended YOC provides a more accurate measure of the return on investment in real estate development because it considers the increase in rental rates over time. It’s a powerful metric for estimating the return on investment of either a new development or multifamily value-add project. On the other hand, untrended YOC uses today’s rates, which are not adjusted to account for projected market shifts or historical growth.
Trended YOC is a superior metric for analyzing and decision-making because it applies:
- Future expectations of future changes in rental income and/or expenses. This consideration of projected market trends is essential when making long-term investment decisions, as real estate is typically not a short-term investment. A property’s current yield may not represent its future yield if market conditions change.
- Market dynamics which fluctuate due to various economic factors such as supply and demand, interest rates, and the general economic climate.
- A more accurate risk assessment.
With trended YOC, investors can assess multiple scenarios based on different trends to understand the potential range of outcomes for their investments. This range of potential outcomes can provide a more comprehensive view of an investment’s potential, allowing us to plan strategically.