Since investing in commercial real estate projects is very costly, developers and investors alike have to use certain metrics to decide whether a particular project will have a good enough return on investment to be worth their time. Development yield, also sometimes referred to as "yield on cost," is one of those very important metrics. Read on below to learn more about what this metric measures, why it's so crucial when making decisions about commercial real estate ventures, and how to calculate it on your own.
What is development yield in real estate?
In real estate, development yield is a metric used to evaluate whether it's worthwhile to develop a particular piece of property. Much like the 1% rule or the rule of 72 in residential real estate investment, this is a back-of-the-envelope calculation that developers often use to help them decide if it's a good idea to take on a specific project.
The initial development yield is calculated by taking the stabilized income that will be generated by the property and dividing it by the total construction cost. Put simply, if the development project presents a high enough yield, the developer is likely to move forward with pursuing it. If not, they're likely to move on to other projects or at least to another location.
Notably, development yield is sometimes also referred to as "yield on cost," which is also the name of a metric used to measure dividend yield of an investment. While these two metrics share a name, it's important to realize that they aren't actually one and the same and that they are calculated much differently from one another.
Why is development yield important in evaluating the success of a commercial property?
Development yield is an important metric in commercial real estate because it tells developers and investors about the potential for return on investment. To put it bluntly, it's extremely costly to develop and construct a new commercial building. If the yield potential for the location of a new development project isn't sufficient, it's highly unlikely that the developers will continue to move forward with the project. If they do, they could risk losing a substantial amount of money.
However, rather than looking solely at the yield potential of a single location or building, it's relatively common to use this metric to compare several different development options. In this case, the project or location found to offer the highest yield would be the one to ultimately win out over the others.
How to calculate development yield
Now that you know more about what development yield is and why it's important in the world of commercial real estate, the next step is to learn how to calculate it. Calculating this figure often requires gathering estimates and doing other subsequent calculations, so it may take some effort to figure out the first few times you do it. However, we've broken it down below in hopes of making the process easier.
The formula for development yield is as follows:
Net Operating Income (NOI) at stabilization / Total project cost
Calculating development yield: A simplified example
Step 1: Figure out the net operating income (NOI)
The first step to figuring out your development yield is figuring out the projected net operating income (NOI) for the property once the project has been completed. Net operating income has the following formula:
NOI = Income generated from property - Operating expenses
To do that, you'll first have to project how much income the completed property can produce. This is usually done by looking at current market rates. Then, you'll have to project your operating expenses, which can include property taxes, insurance, common-area maintenance, and supply costs.
For the purposes of this example, let's say that the completed property has a total revenue of $2 million and operating expenses equal to $635,000 annually. In that case, your NOI equation would look like the following:
NOI = Income generated from property - Operating expenses
NOI = $2,000,000 - $635,000
NOI = $1,365,000
Step 2: Figure out the total construction cost
The next step in the process is figuring out the total construction cost for the project. Again, these numbers will likely be forecasted, but in real estate development, this is the typical formula for this calculation:
Total construction cost = Land acquisition costs + Pre-construction spending + Construction spending
Continuing with the above example, let's say that the property has a total construction cost of $20 million.
Step 3: Find the development yield
In order to find the development yield, you simply divide the net operating income by the total construction cost, meaning that the continued example would look like:
Development yield = NOI / Total construction cost
Development Yield = $1,365,000 / $20,000,000
Development yield = 0.06825 or 6%
Looking at the development yield versus the cap rate
Many investors wonder whether they should look at the development yield or the cap rate when trying to decide which projects to pursue. In reality, they are both important metrics, but they tell you slightly different information.
For example, while the property's yield considers the income produced by the property, it doesn't consider the change in value the property will eventually undergo due to either appreciation or depreciation. That's where the cap rate will come in. While the cap rate will measure potential income compared to property value, it does not account for construction costs.
When used together, these two metrics should provide a much clearer picture of whether a particular development project is worth pursuing.
The bottom line
While no one metric will ever provide the full story on whether a particular development project is worth considering, figuring out the development yield is a good place to start. Put simply, this metric will help you get a better handle on the potential for return on investment. Feel free to use the calculation above as a way to evaluate your potential investments going forward.
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