Understanding Yield-on-Cost

“Consider what would happen to a multifamily property purchased in February 2024 at a 5.5% cap rate (a measure of the one-year yield on a property calculated by dividing NOI by asset value) with 50% leverage. Assume that NOI grows at a 3% CAGR. As interest rates come down, it might be possible to sell at a cap rate of 5.0% five years later, in 2029. That equates to an internal rate of return of roughly 14.5% over five years, which is attractive for a historically stable, in-demand asset class.”

-Ralph Rosenberg, Partner, Global Head of Real Estate at KKR

Hi Nuvo Community,

Introduction:

The term yield on cost and untrended Yield-on-Cost, while lesser known than the more common terms of cap rate, AAR and IRR, provides more context and clarity around the short and long-term investment performance of multifamily and real estate assets in general.

Yield-on-Cost measures the net operating income divided by the total acquisition cost of a property. Unlike a going-in cap rate, Yield-on-Cost takes into account other factors such as renovation costs, redevelopment costs, legal fees, pursuit costs, and generally any costs associated with acquiring a property.

In this article, we will evaluate how total cost, even at a favorable purchase price, can tank an otherwise good-looking investment. But first, let's break down how yield on cost differs from other metrics. First, how does a yield on cost differ from a cap rate? While a cap rate measures NOI and purchase price, an IRR can be quickly adjusted by shortening the investment period or by compressing the exit cap rate. Yield-on-Cost ignores this and proves what your net operating income yields based on the total acquisition cost of a property. One may be able to acquire a property at a 6% going-in cap rate. Still, that same property with a great price per unit on the purchase price may require a significant amount of renovations, restoration of down units, or perhaps it’s being acquired from the lender. It will require additional capital to payoff short-term liabilities to local vendors. Or more simply, placing new debt on the property may require additional reserves, further increasing the total cost of the acquisition.

The Calculation:

Why is it Important?

Understanding the importance of yield on cost is most profound when deciding where to allocate money. During these challenging capital market times and rising interest rates, many investors ask why wouldn’t we just invest in 10-year treasury bonds and call it a day. For example, a large fund could place a sizable chunk of capital into 10-year treasuries, walk away for 5, 7, or 10 years, and receive a 4.5%+/- yield. Outside of IRR and equity multiple, we need to be able to compare what the treasuries are offering vs a multifamily investment apples-to-apples.

To further elaborate on Yield-on-Cost, many investors also look at what is known as “untrended yield on cost”. Untrended simply means, once the business plan is executed and the initial renovations are completed, what is your yield on cost absent any anticipated market growth trends, changes in financing, or anticipated refinance adjustments to the interest rate. In this example and in our models, unless otherwise stated in the model, we take year two income and continue to grow expenses to arrive at the untrended NOI. Essentially, if we complete the renovations, achieve higher rents, and rent growth is flat while expenses continue to climb, how will the investment fare?

Example:

The following is a case study of a real-world property that Nuvo underwrote, located in the southeast. It is a lease-up, Class B property in Florida that is currently 65% occupied. The property has an attractive price per unit given the vintage, however the going-in cap rate is 3.37%. The approach would be to acquire the property using bridge-financing, setting aside a portion of funds as an interest reserve and working capital to cover expenses in the short term to complete the lease-up. This property would be acquired for $40mn, a stabilized cap rate of 9.6% in year two, and a trended yield on cost in year five of 8.56%.

Now let’s say, for a moment, that this property needed additional capital to cover aged payables, clean up down units, and pay vendors who have liens on the asset. Your spread over the exit cap rate went down 48 bps on the untrended yield on cost, and 20 bps on year 1. Take note, the stabilized and going-in cap rate did not change.

Based on the investment criteria Nuvo works within, for an opportunistic investment, we typically target spreads of 50-150 bps between the exit cap rate and untrended yield on cost. The larger the spread, the more risk the investment. In this particular example given the vintage and location, a 6% exit cap rate is used; the untrended yield on cost is 7.17%, a 1.17% spread.

The yield on cost is a metric that can’t be quickly manipulated with slight exit cap rate adjustments, and will not mask what appears to be a great purchase price. The Yield-on-Cost and untrended metrics deserve a bigger seat at the table vs terms like “AAR”.

All the best,

Yuri - Your Real Estate Investigator

Credit: Stuart Keller, Chief Executive Officer, Nuvo Capital Partners

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