Yield-On-Cost (development yield)
Hi,
I've seen discussions in this forum regarding yield-on-cost (development yield), and saw the proper calculation should be: NOI (stabilized year) / Construction cost
What bothers me is in this type of calculation, that we don't take into account the number of years in which the property will continue to exist, so, for example, the comparison of:
- Office space with YOC of 5% that has an economic lifetime of 50 years
- Data Center with YOC of 10% that has an economic lifetime of 20 years
is this comparison might be not equivalent, and the most proper way for comparing them is making an IRR model which will take into account the maintenance cap-ex after 20 years of the Data Center?
Thanks everyone.
Best,
Elad
Maybe we do things differently. For us, it's stabilized NOI / (Purchase price + ALL costs associated (acq. costs, construction costs, loan fees, etc.).
Have you underwritten a data center recently?
no. just investigating why Data Center REITs shows a high development yield (Yield-on-cost) and if that make any sense when comparing to other REITs and real-estates
This should be factored in through a "capex reserve" line item which should be above-the-line. Yes, you might not run into capex costs in your first year or two of operation post-delivery, but after that you will. Some institutional investors have stopped including capital reserves into their underwriting as they need to be more aggressive on their valuations to win deals. These costs are real and if not budgeted for then the yield you are underwriting to is not representative of the true yield.
Don't lenders want/require to see cap-ex reserves even in the first year of operations...or can it be included within the operations reserves? That was my assumption...at least...as it always shows up in pro-formas for multi-family that I see. I suppose it might depend on the asset type.
This is a negotiation. Lenders will either pull an industry standard requirement based on age and condition (i.e. 4% FF&E for hotel, $0.20 for commercial, $200 per unit, etc), capex reserve sized on long-term repairs under a property condition report, or the greater of both. If a building is new/renovated, then a landlord can argue that the capex reserve is not necessary (except for maybe hotels and student housing).
I'm at a lender and we always include an allowance of capex reserves even when the borrower doesn't include it in their model.
I mean, thats exactly what an IRR model is for ... taking time into account. Looking at the YOC goes hand in hand with the IRR profile of the investment on a macro level. You need to look at the YOC and compare it to your exit cap to see if the deal quickly makes sense. I know at a min I need to make a yield spread. From there we will run the IRR model to see those metrics too. Then again if you are a merchant type builder, all you really care about is the YOC and exit cap your investors are buying the project for.
YoC = NOI/(Purchase Price + CapEx)
This can be run for every year throughout the hold period.
I would typically look at the "sustainable" yield on cost which includes both the initial capex day 1 (not just your construction costs) and the ongoing maintenance capex (usually some form of reserve) and deduct it from your sustainable/Run-Rate operating cash flow.
Once you adjust for that, the data centre may still yield more, but you may also be bearing greater risk than for an office building. Not sure why you would even comp these two sectors together?
The IRR may be higher or lower but you'd be bearing different risks in each case due to tenant specificity of the building, technological obsolence risk, and the competition for alternatives, etc.
Hi, Thanks. I agree with you'r analysis- I'm looking to compare this two sectors to see if the data center sector can show more yields than the office sector - exactly because of what you mentioned with the upcoming riskis.
The problem is, I saw that Data Center REITs (digital realty, cyrus one..) shows stabilized year YOC (10%-18%), and of course they don't publish how they calculated it and if they included on-going capex - my opinion is that they didn't.
The problem is that the YOC in Data Center without including the on-going capex is only good for about 15-20 years because of all the mechanical/electrical systems that needs to be replaced after that period of time.
Thanks again for everyone for the answers.
As everyone has been saying, you should never be basing your analysis off of one financial metric alone.
Different investors are driven by different types of returns. For example, you wouldn't compare Office to Codos on a current return (also called unlevered return) basis.
I'd advise that you to do three things in comparing the different asset types: compare a few finance metrics, understand the level of risk associated with the type, and last but not least, understand what kinds of returns the investor will be looking for.
To expand a little on the last item, are they looking for long-term stable cash-on-cash investment, are they risk-adverse, do they have the capacity to fund future Cap-Ex, how soon do they want a 1x multiple, etc?
Umm yeah it's a static return. Same reason you'd probably take a 6.5% RoC on a multifamily building over a 7.0% on a 15-year NNN lease without escalations. This is why we use multiple metrics when evaluating investments
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