Development Yield
Performance Metrics in Real Estate
When looking at any kind of investment opportunity, investors use a variety of performance metrics to determine if the deal meets their criteria. Real estate is no different; investors use a variety of performance metrics when underwriting an investment opportunity. In this paper, we will cover one of these important performance metrics, known as development yield.
Development Yield
Development yield (also known as yield on cost) is a metric used by real estate developers which reflects the percentage of the property’s stabilized net operating income to the total cost of the project. The formula for development yield is as follows:
What Does it Mean for a Property to be Stabilized?
A stabilized real estate asset is one where the property has an occupancy at or above 90%. In other words, at least 90% of the amount of rentable square footage is currently being leased. Additionally, a stabilized property is one that is not presently providing concessions, such as free rent, to tenants.
What is Factored into the Total Project Cost?
The total project cost is the sum of the land costs, hard costs, soft costs, interest, and commissions.
Why do Investors Look at Development Yield?
As an investor, the reward should equal the level of risk. In value-add investing, yield-on-cost reflects the amount of value you get from taking on the risk involved in developing a particular investment. The value could come from increasing the tenant rents and occupancy or decreasing the operating expenses. These actions increase the property’s net operating income (NOI), which is used in conjunction with the cap rate to calculate the value of the property. Development yield is useful for real estate developers in back-of-the-envelope calculations. Seasoned developers have a sense for how much a project will cost to build. Thus, you can easily calculate the development yield by estimating the rents, subtracting the rents by the market operating expenses, and then dividing this result by the developer’s estimated total project cost.
However, it is important to not solely rely on the yield-on-cost as your deciding metric because while the investment may be returning a certain development yield percentage, the overall value of the investment could decrease. This means that, as the investor, you could lose money.
Conclusion
Development yield, or yield-on-cost, is one of many metrics used in professional real estate underwriting analysis. Each investor will have a different minimum development yield to go forward with the investment. Development yield is a relatively simple and easy to understand metric compared to newer metrics like internal rate of return. Nonetheless, it is a very useful one to be aware of.
Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.