You’re likely familiar with the challenge of evaluating investment opportunities. With sponsors presenting different metrics to showcase their deals, it’s crucial to understand which numbers truly matter for your investment decisions. Recently, Yield on Cost (YoC) has gained popularity, with some sponsors even suggesting it should be the primary metric for evaluating deals. But is this the right approach for limited partners seeking reliable passive income?
I don’t believe it is. I still like Cash-on-Cash (CoC) and Internal Rate of Return (IRR) [1].
Understanding Yield on Cost
YoC is defined as ((net operating cost at stabilization) / (total project costs)) * 100.
YoC appears to offer a straightforward way to evaluate development and value-add opportunities. It shows how your stabilized income relates to your total investment, including both purchase price and improvement costs. This can be particularly valuable when evaluating whether proposed improvements will genuinely enhance returns.
For example, if a sponsor is looking do to a significant value add on a property with a current CAP rate of 5%, and projects yield on cost of 10%. In this case, the improvements have doubled the return relative to the costs so it is a potentially attractive opportunity. However, if the YoC is 5%, then you have incurred additional risk, work, and expenses for no increased the return. In this case, the project is likely not worth the risk.
What YoC Misses
Impact of Debt
Since YoC is based on NOI, it does not take into account the debt on the property. Over the past 5 years, we have seen the impact that debt service has on returns to investors. By removing the debt service from the projected return, YoC removes visibility into how the proposed deal structure impacts the investor returns. A deal can have a YoC well over 10%, but the actual returns to the investors could be less than half of that.
Time Value of Money
When focusing on cash flow, timing matters. YoC focuses on a single point in time, the return when the property is first stabilized. That could be on purchase, in 3 years, in 5 years, or even longer. The time required to stabilize the property is not factored in to the return.
Appreciation Potential
YoC does not take into account any appreciation in the property. While the cost of capital improvements is included, there is no insight into whether or not that investment has increased the overall value of the property over the long term.
Better Metrics for Cash-Flow Investors
As a cash flow focused investor, YoC doesn’t provide the information I care most about – how much money do I get back and when do I get it. Instead, I recommend:
Cash-on-Cash (CoC) Return
CoC is the expected return each year of the project, taking into account all of the expenses except taxes (which are investor specific). By taking into account the projected cost of all debt the results are much better aligned with investor payments and provide insight into how they are expected to change year-over-year.
Internal Rate of Return (IRR)
While a more complicated calculation, IRR provides a comprehensive view of the investors return. It accounts for the time value of money, the cost of debt service, and the return generated from appreciation as well as cash flow.
Making Better Investment Decisions
For professionals building passive income streams, consider this framework:
- Start with CoC to understand your actual cash flow.
- Use IRR to evaluate total return potential.
- Consider YoC as a supplementary metric, especially for development or heavy value-add deals, and compare it with CoC and IRR to understand the impact of the debt on your overall returns.
- Always ask sponsors to provide multiple metrics – transparency creates better alignment.
Remember, the goal isn’t just to find deals with attractive numbers, but to build a reliable passive income stream that supports your journey to financial freedom. Understanding these metrics helps you make informed decisions aligned with your long-term goals and identify when a project is not a good fit.
For additional reading:
This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.