CRE 101 · deweyluong.realtor
Yield on Cost: The Cap Rate You Build
Every developer hits the same moment. The land is under contract, the drawings are getting serious, and somebody has to answer the question out loud: is this thing actually worth building?
Yield on cost is the number that answers it. It is the most important number in a development feasibility check, and once you understand it, you understand how developers think.
The definition, in plain English. Yield on cost is the property's stabilized annual net operating income (NOI), divided by the total cost to develop it.
That is it. One fraction. The top is what the finished building earns in a normal, stabilized year. The bottom is everything you spent to make it exist.
It looks like a cap rate, and it should. It is basically the cap rate you create by building, instead of the cap rate you pay when you buy an existing building. The whole game of development is building at a yield on cost higher than what the market would pay for the finished product. That gap is your profit.
Here is the formula:
Two things to get right:
- Stabilized NOI means the income in a normal year, after the building is leased up. Not year one. Not the rosy pro forma month. Realistic rent, realistic vacancy, real operating expenses.
- Total development cost means everything. Land, construction, architect and permit fees, tenant improvements, leasing commissions, contingency, and the interest you carry on the construction loan while you build. Leave line items out of the bottom number and you are lying to yourself. The market always collects.
Worked example. Every number below is assumed, for teaching. It is a realistic shape of a deal, not a real project, not a quote, and not a promise of what any site would cost or earn.
The project: a 12,000-square-foot neighborhood retail building on a commercial corridor in Gwinnett County, Georgia.
Total development cost:
| Line item | Math | Amount |
|---|---|---|
| Land (assumed) | — | $600,000 |
| Hard costs (construction) | 12,000 SF × $140/SF | $1,680,000 |
| Soft costs (architect, engineering, permits, fees) | 15% of hard costs | $252,000 |
| Tenant improvements | 12,000 SF × $20/SF | $240,000 |
| Leasing commissions | 6% of first-year rent | $17,280 |
| Contingency | 5% of hard + soft costs | $96,600 |
| Construction loan interest (carry) | assumed | $80,000 |
| Total development cost | sum of all lines | $2,965,880 |
Stabilized NOI:
| Line item | Math | Amount |
|---|---|---|
| Gross rental income | 12,000 SF × $24/SF/year (NNN) | $288,000 |
| Less vacancy and collection loss | 5% | −$14,400 |
| Effective gross income | $288,000 × 95% | $273,600 |
| Less owner operating expenses | 12,000 SF × $3/SF | −$36,000 |
| Stabilized NOI | $237,600 |
Yield on cost: $237,600 divided by $2,965,880 is 8.0%.
You spent about $2.97 million all-in, and the stabilized building earns about $237,600 a year. Your created yield is 8.0%.
How to read the result: the development spread
Now compare that 8.0% to what the market pays for a finished, stabilized building like this. Assume a 7% market cap rate for illustration. That is an assumed figure for teaching, not a quoted market rate for any specific property or submarket.
- Yield on cost: 8.0%
- Market cap rate (assumed): 7.0%
- Development spread: 1.0% (100 basis points)
That spread is the development premium. It is the extra return you earn for taking construction risk, lease-up risk, and time risk instead of just buying a finished building at 7%.
A common guideline developers use: they want roughly 150 to 250 basis points of spread over the market cap rate before a project clears their hurdle. That is a rule of thumb, not a law. Every developer sets their own required return based on risk and capital cost. But the logic is the same everywhere. The spread has to be wide enough to pay you for everything that can go wrong between groundbreaking and stabilization.
Here is the go/no-go connection. Take the example one step further:
- Implied value of the finished building: $237,600 divided by 7% = $3,394,286
- Development profit: $3,394,286 − $2,965,880 = $428,406
- Profit on cost: $428,406 divided by $2,965,880 = 14.4%
The project creates about $428,000 of value above its cost. At these assumptions, the answer is go. The project is worth building.
Now stress-test it, because feasibility is a range, not a number. Suppose rents come in 10% softer than hoped. NOI drops to $213,840. Yield on cost becomes 7.2%. The spread over the assumed 7% cap rate shrinks to 20 basis points, and the development profit nearly evaporates. Same building, same dirt. Now the answer is no-go, or back to the drawing board to cut costs or find more rent.
That is why developers run the sensitivity before they run the bulldozer. Yield on cost turns "I think this will work" into arithmetic.
Three mistakes that kill feasibility
- Underestimating costs, especially the ones that are not construction. The building itself is the easy part to price. What sinks budgets is everything around it: impact fees, water and sewer tap fees, off-site road improvements the county requires, soils surprises. If your total development cost is missing line items, your yield on cost is a fantasy. Price the whole project, not the fun part.
- Rosy rent and occupancy assumptions. Feasibility models love to assume the building leases at top-of-market rents the day the certificate of occupancy is issued. Reality: lease-up takes months, sometimes over a year, and the first tenants usually sign below your pro forma. Run your yield on cost on the stabilized number, the year the building is actually full, not the brochure number.
- Ignoring the time value of the carry. Every month of delay is another month of loan interest, taxes, and insurance with zero income. Permitting, construction, lease-up, all of it. That carry sits in the total cost whether you modeled it or not. A project that pencils at an 8% yield on a 12-month timeline can quietly become a 7% yield at 18 months. Time is a cost. Model it.
The one-line takeaway. Yield on cost is the cap rate you build. If it does not beat the market cap rate by a wide enough margin to pay you for the risk, do not build.
Looking at a piece of land or a ground-up project in Gwinnett or Metro Atlanta? Reply with the address and your rough numbers. I will run the yield on cost with you and tell you straight whether it clears.
Túy “Dewey” Luong, CCIM | SERHANT. Georgia | 678-707-2498 | dewey.luong@serhant.com | deweyluong.realtor
Frequently asked questions
- Is yield on cost the same as cap rate?
- Close, not the same. Cap rate is the return on a building that already exists, at the price you pay for it. Yield on cost is the return on a building you create, at the total cost to build it. Same formula shape. Different bottom number.
- What spread should I require before I build?
- Most developers want 150 to 250 basis points over the market cap rate before the risk is worth it. That is a guideline, not a law. Your lender, your timeline, and your own risk tolerance set the real number.
- Can the yield on cost look good and the project still fail?
- Yes. If lease-up drags or costs creep, the stabilized income shows up late or not at all. Run the math on realistic rent and a realistic timeline, not the best case, and stress-test it before you commit.