If I would dumb down our underwriting process to one metric, I’d say it is understanding the true underwritten stabilized Yield On Cost.
The Yield On Cost metric is manipulable, as all metrics are, but it is less manipulable than say… the IRR metric.
You calculate it by taking the stabilized NOI divided by your total cost (acquisition, closing cost, capex, etc.) And because it is not influenced by the duration of the deal’s hold period, and doesn’t include exit cap rate assumptions, like the IRR does, it paints a solid picture of the quality of the opportunity at hand. (Unlike the IRR, which is so manipulable, that it’s impossible to tell if a deal is good just by using the metric.)
In laymen’s terms, the Yield On Cost (or YOC) tells you how much income is being generated and the property level relative to how much money it took you to get there. And isn’t that the most important thing?
The YOC metric is very helpful in two ways. For one, it helps you get a real understanding of where your yield is relative to the cost of your debt.
If you have 4.5% interest debt on a 30 year amortization, and your yield on cost is at 7%, you are in a positive leverage situation. That is because the loan constant on 4.5% interest debt with a thirty year amortization is 6.08%, and since your property level yield (YOC) is HIGHER than your debt cost (or loan constant), your cash on cash returns will benefit. For Livi Kapital, being positively levered is something that we expect from all deals that we invest in.
The metric also gives you a sense for how much of a cushion you have relative to market cap rates.
If you stabilize at a 7% yield on cost, and market cap rates are at 5% for similar assets, you have 200 basis points of cushion (this cushion is also known as spread; cap rates could go up 199bps and theoretically you’d still make money on the sale.)
As interest rates have gone up, I’ve seen large check investors notch UP their expectations for YOC.
Development deals were getting capitalized to a 6% YOC just a year ago.
Now, it would be difficult to do a deal below a 7% yield on cost.
Yesterday, I saw my first Multifamily deal in ages that is stabilizing to an 8% Yield on Cost. (on the sponsor’s numbers). (The date is 2022-09-18…)
Multifamily acquisitions were getting capitalized to a 5.5% Yield On Cost just a year ago.
I’m very surprised by how often I see operators not taking their Yield On Cost into consideration.
Very many groups get excited from a high IRR, but if your deal shows a low Yield On Cost, despite the high IRR, you may be incurring more risk than you think. (because there is no spread)