Updated · Part of the CRE investment glossary
How yield on cost works
A cap rate divides NOI by what a property is worth. Yield on cost divides the NOI a project is expected to reach by what it will cost to get there. For a development or a renovation, that is the question that matters: does the income you are building justify the money you are spending?
The test is the gap between the two. If a project yields 7.8% on cost and similar finished properties trade at a 6.0% cap rate, the market would pay more for the finished income than it cost to create. That gap is the development spread, and it is what pays for the risk of building, leasing and waiting.
The formula
Use stabilized, not in-place, NOI — and the full cost, not just the purchase price:
Yield on cost = stabilized NOI ÷ total project cost Development spread = yield on cost − market cap rate Value created ≈ (stabilized NOI ÷ market cap rate) − total project cost
- Stabilized NOI: the NOI expected once the work is done and occupancy reaches a normal level.
- Total project cost: purchase price or land, hard and soft costs, closing costs and any reserves the project funds.
- Market cap rate: what buyers pay for comparable stabilized properties. Value created is before selling costs and the loan payoff.
Worked example: a renovation
A sponsor buys an apartment property for $8,000,000 with $520,000 of in-place NOI — a 6.5% going-in cap rate. Adding $200,000 of closing costs and a $1,800,000 renovation, the project costs $10,000,000. After renovation the sponsor projects $780,000 of stabilized NOI.
Yield on cost is $780,000 ÷ $10,000,000 = 7.8%. If finished properties nearby trade at a 6.0% cap rate, the stabilized property is worth about $780,000 ÷ 0.06 = $13,000,000, so the work creates about $3,000,000 of value on $10,000,000 of cost — a 180 basis-point development spread and a 30% profit on cost before selling costs.
| Measure | Calculation | Result |
|---|---|---|
| Going-in cap rate | $520,000 ÷ $8,000,000 | 6.5% |
| Yield on cost | $780,000 ÷ $10,000,000 | 7.8% |
| Development spread | 7.8% − 6.0% market cap rate | 1.8% (180 bps) |
| Stabilized value | $780,000 ÷ 0.06 | $13,000,000 |
| Value created | $13,000,000 − $10,000,000 | $3,000,000 |
Yield on cost vs cap rate vs cash-on-cash
The going-in cap rate is today’s NOI over the purchase price: what you buy. Yield on cost is the projected stabilized NOI over everything you will spend: what you build. Cash-on-cash is the cash flow after debt service over the equity: what investors receive in a year. A value-add plan usually shows a modest going-in cap rate, a higher yield on cost, and cash-on-cash that is low during the renovation and rises after.
Underwriters also distinguish an untrended yield on cost, which uses today’s rents on the finished product, from a trended one, which grows rents to the stabilization date. The untrended figure is the more conservative test of whether the plan works without rent growth.
Common mistakes
Yield on cost is easy to flatter:
- Using the purchase price instead of total project cost, which leaves out the renovation that produces the higher NOI.
- Using trended NOI and calling it untrended, or comparing a trended yield on cost with today’s cap rate.
- Ignoring lease-up: stabilized NOI arrives after months of vacancy and concessions, which the cost budget should carry.
- Assuming the exit cap rate equals today’s market cap rate; if cap rates rise during the project, the spread shrinks.
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.