Updated 4 months ago on .
Prioritize Yield on Cost Over Cap Rates
When I sit down with brokers, the question I hear most often is predictable yet revealing:
“What metrics do you use to evaluate a development deal?”
My response often catches them off guard, especially those steeped in traditional real estate underwriting:
We don’t chase cap rates. We focus on Yield on Cost.
This distinction isn’t just a nuance—it’s the cornerstone of our development philosophy. Let’s unpack why cap rates take a backseat and why Yield on Cost (YoC) drives our decisions, offering a framework that any developer or investor can apply to make smarter, more disciplined choices.
Cap Rate vs. Yield on Cost: Understanding the Difference
At its core, the difference between cap rate and Yield on Cost is a matter of perspective: one is about selling, the other about building.
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Cap Rate: This is the market's valuation tool. It measures the relationship between a property's Net Operating Income (NOI) and its market value or sale price. The formula is simple:
Cap Rate = Net Operating Income ÷ Market Value
Cap rate answers the question, “What is this stabilized asset worth to a buyer in today’s market?” It’s critical for assessing exit potential—how much a property might fetch once it’s fully leased and operational. But it’s backward-looking, tethered to current market conditions, and assumes the asset is already built and generating income.
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Yield on Cost: This is the developer’s lens. It measures the return on the total cost to build the project, calculated as:
Yield on Cost = Net Operating Income ÷ Total Project Cost
YoC answers a more fundamental question: “Is it worth taking on the risk, time, and capital to build this project in the first place?” It accounts for construction costs, land acquisition, financing, and all the complexities of bringing a project to life.
In short:
- Cap rate is about what the asset is worth to the next buyer.
- Yield on Cost is about whether it’s worth building today.
Why the Spread Is the Key to Smart Development
Our underwriting hinges on the spread between Yield on Cost and the market’s anticipated exit cap rate. We target a spread of 150–200 basis points (1.5–2%) to ensure the project delivers a meaningful return relative to the risks involved.
Here’s why the spread matters:
- Risk Buffer: Development is inherently unpredictable—construction delays, cost overruns, or market shifts can erode returns. A healthy spread provides a cushion, ensuring the project remains profitable even if things don’t go perfectly.
- Execution Reward: A tight spread (e.g., 50 basis points) means your equity is working overtime for minimal gain. A robust spread rewards the effort, expertise, and capital required to execute a complex project.
- Market Flexibility: A strong spread gives the project breathing room if market cap rates rise (lowering asset values) by the time of stabilization. It protects against downside risk while preserving upside potential.
If the spread is too narrow, the deal is a gamble. If it’s healthy, the project has resilience and profitability baked in from the start.
Example: Putting Numbers to the Concept
Consider a hypothetical project:
- Total Project Cost: $10 million
- Projected NOI: $800,000
- Market Cap Rate: 5.5%
Yield on Cost: $800,000 ÷ $10,000,000 = 8% Spread: 8% (YoC) - 5.5% (cap rate) = 2.5% (250 basis points)
This spread of 250 basis points signals a strong deal, offering a margin for risk and reward. If the YoC were only 6% (a 50-basis-point spread), the deal would be far less attractive, as it leaves little room for error or market fluctuations.
Our Benchmark: 7%+ Yield on Cost
We’ve set a clear threshold: a minimum Yield on Cost of 7%. This isn’t an arbitrary number—it’s a disciplined standard informed by market dynamics and our experience. A 7%+ YoC ensures the project generates enough cash flow to justify the investment, cover risks, and deliver real returns.
If a project can’t meet this benchmark, we don’t manipulate the numbers to make it work. We don’t stretch assumptions or bank on speculative market shifts. Instead, we walk away.
This discipline is what separates successful developers from those chasing mirages. Smart real estate isn’t about forcing deals to pencil—it’s about saying “no” when the math doesn’t add up.
Why Chasing Cap Rates Can Lead You Astray
Cap rates are seductive. They’re widely used, easily understood, and dominate real estate conversations. But leaning too heavily on cap rates for development decisions is a trap. Here’s why:
- They’re Market-Dependent: Cap rates reflect current market sentiment, which can shift rapidly due to interest rates, economic conditions, or investor demand. A low cap rate today might not hold when your project stabilizes years down the line.
- They Ignore Development Risk: Cap rates assume a finished, income-generating asset. They don’t account for the blood, sweat, and capital required to get there.
- They Encourage Speculation: Focusing on cap rates can lead developers to bank on future market compression (lower cap rates) to justify a deal. This is a recipe for overpaying or overleveraging.
Yield on Cost, by contrast, keeps you grounded in the realities of building. It forces you to confront costs, risks, and execution head-on, ensuring decisions are rooted in fundamentals, not wishful thinking.
The Bigger Picture for Bigger Pockets: Discipline Drives Returns
Our philosophy boils down to this: Deals are made on the front end, not the back end. A project's success is determined by the decisions you make before breaking ground—land price, construction budget, financing terms, and realistic NOI projections. Chasing cap rates or banking on a hot exit market is speculative. Building to a strong Yield on Cost is strategic.
By prioritizing YoC, we ensure:
- Real Returns: The project generates cash flow that justifies the investment.
- Risk Mitigation: A healthy spread protects against cost overruns or market shifts.
- Execution Focus: We’re rewarded for delivering a quality project on time and on budget.
Takeaway: Build Smart, Don’t Chase
If you’re evaluating a development deal, shift your focus from cap rates to Yield on Cost. Ask yourself:
- Does the project deliver a YoC of 7% or higher?
- Is there a 150–200 basis point spread over the market cap rate?
- Does the deal reward execution and mitigate risk?
If the answer to any of these is “no,” it’s time to reconsider. In real estate development, discipline isn’t just a virtue—it’s the difference between a deal that makes dollars and one that doesn’t make sense.