Yield on Cost vs. Cap Rate for Apartment Deals
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Cap rate is net operating income (NOI) divided by price or value. Yield on cost is the stabilized NOI a business plan targets divided by the total cost of the project, including the purchase price, closing costs, renovation and starting reserves. Cap rate describes a building as it is, and yield on cost describes what the buyer expects to earn on every dollar put in after the plan is done. Sponsors who raise capital with DoorRaise should state which one they mean when they quote a "return" in a deck.
This post defines both, shows a hypothetical example and explains why the gap between yield on cost and the exit cap rate matters. It builds on our guide to what a good cap rate is.
What is the difference between the two?
Cap rate uses the NOI today (or the trailing year) and the price. It is how the market prices a building. Yield on cost looks forward: it asks what the stabilized NOI will be after renovations and better management, and divides by everything that had to be spent to get there. Our underwriting basics post explains NOI in detail.
A hypothetical example
This example is hypothetical, for illustration only. A 50-unit building is bought for $5,000,000 with $325,000 of current NOI.
| Line | Amount |
|---|---|
| Purchase price | $5,000,000 |
| Closing costs | $150,000 |
| Renovation ($8,000 x 50 units) | $400,000 |
| Total project cost | $5,550,000 |
| Going-in cap rate ($325,000 / $5,000,000) | 6.5% |
| Added rent from renovations (50 x $1,500) | $75,000 |
| Stabilized NOI ($325,000 + $75,000) | $400,000 |
| Yield on cost ($400,000 / $5,550,000) | about 7.2% |
If the building could be sold at a 6.5% exit cap rate, value would be $400,000 / 0.065, about $6.15 million. That is about $600,000 above the $5.55 million cost, before debt, fees and selling costs. The spread between 7.2% yield on cost and 6.5% exit cap is what creates the value.
What if the plan underdelivers?
Suppose the rent premium comes in at half, so stabilized NOI is $362,500. Yield on cost drops to about 6.5%, equal to the exit cap rate, and the plan creates no value. If the exit cap rate also rises to 7.0%, value is about $5.18 million, below the $5.55 million spent. See exit cap rate assumptions. A $400,000 renovation can lose money in this made-up example if either the premium or the exit market goes the wrong way.
How should you use yield on cost?
- Use it to compare renovation plans for the same building or buildings in the same market.
- Pair it with the renovation budget, so the cost side is documented.
- Include everything: closing costs, reserves, interest during renovation and lost rent.
- Do not use it as a promise of what investors earn. Investors' returns depend on debt, fees, the promote and timing. See equity multiple, IRR and cash-on-cash.
How DoorRaise fits in
DoorRaise helps sponsors raise equity for apartment buildings with 5 or more units under Rule 506(b) or 506(c). It prepares the offering documents from the sponsor's inputs, coordinates escrow with Enterprise Bank & Trust, collects investor funds by wire only and handles filings. The deal page can show investors the business plan and the projection assumptions, labelled as projections. DoorRaise does not verify a seller's or a sponsor's numbers; sponsors must check what they present.
DoorRaise is for apartment buildings with 5 or more units, and sponsors can launch their deal here. Setup is $1,500 (non-refundable), and the administration fee is $5,000 a year from closing.
To get started, create your sponsor page or see the fees.
FAQ
What is yield on cost in real estate?
It is the stabilized NOI a business plan targets divided by the total project cost, including purchase, closing and renovation.
What is the difference between yield on cost and cap rate?
Cap rate uses current NOI and price. Yield on cost uses projected stabilized NOI and total cost.
What is a good yield on cost?
It depends on the market's exit cap rate, the risk of the plan and the financing, so there is no single number. What matters is the spread above the exit cap rate and how it holds up in a downside case.
Is yield on cost the same as return on investment?
No. It is an unlevered, pre-fee measure. Investor returns also depend on debt, fees, taxes and timing.
Why does the exit cap rate matter?
Because it converts stabilized NOI into a sale value. If it is higher than assumed, the value falls.
Sources
- Fannie Mae, Multifamily fixed-rate mortgage loans
- 17 CFR 240.10b-5, Employment of manipulative and deceptive devices
This article is general information, not legal, tax or investment advice. Talk to a securities attorney and a CPA about your deal. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.