What is the difference between yield on cost and cash on cash returns in commercial real estate?

Yield on Cost vs Cash on Cash Returns: What's the Difference?

"Yield on Cost" in commercial real estate refers to the ratio of annual income generated by a property to the total cost of the property, including purchase price and renovation expenses, offering insight into the overall return on investment over time. On the other hand, "Cash on Cash Returns" specifically measures the annual return on the actual cash invested in the property, typically focusing on the initial year or a short-term period. While Yield on Cost provides a broader, long-term perspective on investment performance, Cash on Cash Returns give an immediate, annual perspective based on actual cash flow.

Below is a more detailed overview of each term and the most important differences between them:

Yield on Cost

1. Definition: Yield on Cost (YOC) is a measure of the profitability of a real estate investment and is calculated as the property’s annual income divided by the total cost of the property (which includes the purchase price and any capital improvements).
2. Formula: Yield on Cost = Annual Net Operating Income (NOI) / Total Investment Cost × 100%
3. Purpose: YOC is used to evaluate the efficiency of the initial investment and any subsequent capital improvements. It reflects how well an investment is performing relative to the total capital invested.
4. Usage: It is particularly useful in development projects or repositioning of assets where significant capital improvements are made after the initial purchase.

Cash on Cash Return

1. Definition: Cash on Cash Return is a rate of return on a real estate investment property based on the cash income earned by the property and the amount of cash invested by the investor.
2. Formula: Cash on Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested × 100%
3. Purpose: This metric is used to evaluate the cash income on the cash investment made and is a good indicator of an investment’s short-term profitability.
4. Usage: Cash on Cash Return is particularly useful for investors who are focused on the annual income of a property and is commonly used in scenarios where financing is involved.

Key Differences

• Basis of Calculation: Yield on Cost is based on the total investment cost (purchase plus improvements), while Cash on Cash Return is based on the actual cash invested.
• Reflection of Performance: Yield on Cost reflects the overall efficiency of the investment including capital improvements, whereas Cash on Cash Return focuses on the return on the actual cash invested in a given year.
• Use in Analysis: YOC is more commonly used in development or repositioning scenarios, while Cash on Cash Return is a measure used for assessing the ongoing income performance of an investment.

Both metrics are valuable for investors in commercial real estate, but they serve different purposes. Yield on Cost gives a broader view of the investment's performance over time, including value-add strategies, while Cash on Cash Return is a more immediate measure of the cash income relative to the cash invested.