Is this deal worth the risk?

Is there risk in real estate? You bet there is!

So how can investors measure this risk?

One tried and true method is to calculate the Yield on Cost and evaluate the Investment Spread (development spread).

The more risk you are taking on a real estate investment, the higher the investment spread should be.

To calculate the investment spread, we need to calculate the Yield on Cost and determine the Market Cap Rate.

Yield on Cost

Simply put, yield on cost is the net operating income (stabilized NOI) divided by the total project cost.

With any value-add investment, investors are taking risk when spending money to renovate a property. They are betting the additional capital spent will add value to the property as a result of being able to charge higher rents and/or lower expenses.

Yield on cost helps you evaluate how much value (additional yield) you’re earning in exchange for taking that risk.

Market Cap Rate

The current market cap rate is the cap rate at which very similar properties in size, location, amenity, and age are trading for in a given market. Look for properties that have the same amenity package as well.

Unfortunately, determining the market cap rate can be subjective at times.

In my opinion, the best ways to determine a current market cap rate are:

  • Talking to local brokers
  • Appraisal reports
  • Third party data reports (CoStar)
  • Recent sale comps
  • Market knowledge

You shouldn’t rely on one source. This is where having market knowledge and really understanding the location will be beneficial.

Investment Spread

This is where the investor will determine if the real estate investment if the risk is worth taking.

YOC – Market Cap Rate = Investment Spread

So if you calculate your stabilized yield on cost to be 6% in a market where similar properties are trading at 5.5%, the investment spread (additional yield) would be 0.5%.

Is it worth the risk to earn 50 bps more on the value-add deal? If the answer is no, you’re better off buying a stabilized property at a 5.5% cap rate, since this could potentially present less risk. If the answer is yes, then you can pursue the value-add opportunity.