Poll: Yield on Cost calc
Been in this game for some time and still seeing 2 different camps when it comes to the yield on cost calc. Do you include financing costs in the denominator or not?
Example:
NOI = $9
Land + hard + soft = $90
Interest reserve + operating deficit = $10
Do you say YOC is 9 / 90 = 10% or 9 / 100 = 9%?
The logic behind both makes very good sense. So it’s more about consistency. How do you people do it?
At my firm, yoc would be 9/90, total costs ex interest and financing costs
At our firm it’s based on the all in costs.
What is the rationale on excluding the financing costs? That all the other costs are developer controlled so using financing does not reflect a true yield on owner costs?
Include everything, wildly disingenuous to exclude and no logic or reasoning to do so
The logic to exclude is that you're hurting yourself by having higher leverage or for having debt at all. I.e., an unlevered investor would underwrite a 10% yield since there are no financing costs and a levered investor will underwrite the 9% yield.
I tend to agree with using all-in cost, but you're being a little obtuse about considering the other perspective here.
Yeah higher leverage and the costs associated is still a cost, the unlevered investor has lower costs, I don't know why you would complicate it anymore than that and take reality out of the picture by excluding a very legitimate cost that is variable based on how you want the cost to look. That's like saying I could build a building class A or class A-, but I'll do my YoC on the A- project cost because this guy over here could also build to an A-.
What a wonderful world it would be if I could go buy deals entirely exclusive of my cost of capital.
I understand the logic of excluding FC, but have never seen them excluded from YoC
why tf would you exclude financing costs? Those are capitalized by debt + equity which have to be repaid........
Brokers advertised cap rates always don't that's for sure! They also don't include their fees
they also don't include realistic growth assumptions
+3% YoY squad up
9/100
Anyone making claims about the effects of leverage should be presenting levered and unlevered IRRs to reflect how the financing affects the deal
Agreed. On that note, do you all include capitalized financing in your unleveraged IRR calcs? I see the merits of both ways here too - running unleveraged IRR on the full project budget inclusive of capitalized financing and comparing it to the leveraged IRR in my mind shows the true leverage amplification effect on the project returns (i.e. here's the IRR if we funded 100% of the project budget and received NCF, and here's the return if we funded only 40% and only got back CFADS). But unleveraged IRR w/o financing capitalized makes sense too as it is the returns as if no debt is ever placed on the project. This decreases what the leverage amplification looks like too as you're excluding ~2% of the budget.
How do PE firms measure it for deals with PIK interest? What do REITs or ODCE funds reporting unleveraged IRR do? Haven't ever been able to nail down this topic for transactions with heavy capitalized financing costs.
I think most investors think about it intuitively and that reflects on how it should be presented. Leveraged IRR implies that you have a financing structure in place and it is relevant to how the deal is setup and/or will perform. Unlevered IRR implies that you are paying for everything with straight cash. I think because we live in a world of low rates we aren't used to what the older generation who saw deals in the 80s/90s are used to seeing where there is an actual thought process as to whether you should finance deals and more specifically, how you should finance deals.
Can't speak to PIK as I've never dealt with it.
Seen this metric evolve over time to capture financing costs.
For all you RE purists out there, the thought behind RoC excluding FCs is presenting an unlevered, pure and unadulterated view of the deal on a static basis.
I could care less which one people I work with use, as long as it is properly annotated and disclosed appropriately.
We always include financing costs, agree with what most have said above. Also, from a high level part of looking at your YoC for a development is obviously to achieve some spread over what you think the exit cap would be. Market cap rates inherently rely to some degree on acquisition financing and the cost of it, so to me excluding financing costs from your YoC calc would make that YoC-Exit Cap spread a little inflated and misleading?
Slightly different question, but how does everyone look at a Hard Cost Inflation Factor when calculating your Untrended YoC? Include or no? I've seen it done both ways, suppose there are arguments for each approach.
Regarding financing, I think you look at an untrended number without inflation and a trended YOC (includes inflation). That way you see how much additional spread you pick up due to trending rents, costs, expenses, etc.
I take the full hard cost budget as it’s approved/expected to be spent. If there’s inflation contingency in there, I keep it. Just like any other contingency
I see the merits of both but have always included financing costs as it’s total costs capitalized in the deal, so in my opinion, it should be included.
I think the important thing to note here is that neither answer is wrong and both answers are correct. Firms will all do it differently. But the importantly thing is that you underwrite deals similarly each time. This way, you can compare each new deal apples to apples. If your firm always excludes financing costs in the YOC calculation, that’s ok - it’s not like the deal level returns are different. What’s important is that you recognize when you see a good deal based on how your firm (or more importantly you) look at deals. If you always look at it the same way, you’ll hopefully know when you see a good deal for your firm. This is where the art comes in over the science. If to person A, who excludes financing costs, it’s a 10% cap, but to person B who includes financing costs, it’s a 9% cap rate, the returns will be the same even though one ‘looks’ better. But the firm is used to seeing it this way so people are aware of what increases the numbers.
Well put
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