Yield on cost only creates value when it beats the market cap rate on a fully loaded cost basis.
Yield on cost is stabilised net operating income divided by total project cost. An industrial build-to-core project costing $80M that stabilises at $5.6M of NOI has a yield on cost of 7.0 per cent. Against a 5.75 per cent market cap rate, the finished asset is worth about $97.4M, so the gap between the two yields is the value the development creates.
Worked in full in Real Estate Fund Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Yield on cost is stabilised net operating income divided by total project cost. It is the metric for development and heavy repositioning, where a cap rate on in-place income means little until the asset is leased. The going-in cap rate looks at what the building earns today. Yield on cost looks at what it will earn once the business plan is finished, measured against everything spent to get there.
The industrial build-to-core case in Chapter 8 shows the arithmetic. Total cost is $80M. Stabilised NOI is $5.6M. Divide one by the other and the yield on cost is 7.0 per cent. The market cap rate for the finished, leased building is 5.75 per cent. Capitalise the same $5.6M at that rate and the implied value is about $97.4M.
| Line | Definition | Figure |
|---|---|---|
| Total project cost | Purchase, hard and soft costs, fully loaded | $80M |
| Stabilised NOI | Income once leased up | $5.6M |
| Yield on cost | NOI divided by total cost | 7.0% |
| Market exit cap rate | Pricing for the stabilised asset | 5.75% |
| Implied stabilised value | NOI divided by exit cap | about $97.4M |
The value is created in the gap between the two yields. A building that costs $80M to deliver and is worth about $97.4M on completion has manufactured value, because the developer bought income at 7.0 per cent and the market will pay for it at 5.75 per cent. The same test appears in the book's general form: if the stabilised market cap is 5.25 per cent and the project yields 6.50 per cent on cost, value is being created, in theory.
The ratio is only as honest as the cost it divides into. The book insists on a “fully loaded” basis. That means financing costs, developer fees where they apply, capitalised interest, leasing commissions and tenant improvements, all inside total cost. Leave them out and the yield on cost rises on paper while nothing about the building has changed.
Cost risk shows up immediately. If costs rise 10% and NOI does not move, yield on cost compresses at once, and the spread over the market cap rate narrows with it. A development that clears its hurdle at budget can stop clearing it after one round of change orders. That is why the book pairs yield on cost with a capex contingency of at least 10% of the renovation budget in its illustrative strategy memo.
A yield on cost above the market cap rate does not prove a profit. The 7.0 per cent in the worked case only becomes $97.4M of value if lease-up timing, rents and operating expenses arrive as underwritten. The book calls the spread value creation “in theory”. The number is a claim about the future, priced in today's cap rate.
Yield on cost also frames whether the project can be refinanced. Lenders size loans on stabilised income: debt service coverage is NOI over annual debt service, and debt yield is NOI over the loan amount. Both start from the same NOI that sits in the numerator of yield on cost. If the stabilised NOI is overstated, the refinancing fails on the same assumption that flattered the development spread.
Investment committees turn the metric into a guardrail. The illustrative strategy memo in Chapter 2 sets these underwriting boundaries:
The exit cap rule matters as much as the yield. If the exit cap is treated as a plug to hit a return target, the spread between yield on cost and exit cap can be made to say anything. Linking the exit cap to the rate regime, and assuming it widens rather than compresses for value-add work, keeps the comparison honest.
Compute yield on cost on a fully loaded cost basis, not on purchase price plus a headline capex figure. Compare it with the market cap rate for the stabilised asset, not with the going-in cap rate on today's income. Then run the two inputs that move it most. Push costs up 10% and see what is left of the spread. Push the exit cap out by 25 to 100 bps, the range Chapter 8 gives for exit sensitivity, and see whether the implied value still clears total cost.
If the deal only works at budget and at today's cap rate, it relies on a perfect exit window. A committee should see that in the model before it approves the capital. The companion workbook builds the build-to-core case live, with the yield on cost, the market cap and the implied value linked by formula. It is free on the Real Estate Fund Management companion page.
There is no fixed number: a good yield on cost is one that clears the market cap rate for the stabilised asset. In the worked industrial case, 7.0 per cent against a 5.75 per cent market cap implies about $97.4M of value on $80M of cost. An illustrative value-add memo sets a minimum going-in yield on cost of 5.25%.
A cap rate divides NOI by value or purchase price. Yield on cost divides stabilised NOI by total project cost, including capex, financing costs and leasing costs. A project yielding 6.50 per cent on cost where stabilised assets trade at a 5.25 per cent cap is creating value, in theory, because it builds income cheaper than the market buys it.
Use a fully loaded basis: purchase price, hard costs, soft costs, financing costs, developer fees where applicable, capitalised interest, leasing commissions and tenant improvements. Omitting them overstates the yield. On an $80M project with $5.6M of stabilised NOI the yield is 7.0 per cent, and a 10% cost overrun compresses it immediately.
This article is one calculation from Real Estate Fund Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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