Introduction
Real estate development is a complex field with numerous variables influencing cash flow projections. Traditional metrics like Internal Rate of Return (IRR) and Net Present Value (NPV) are commonly used to evaluate projects. However, these metrics can sometimes be skewed by speculative assumptions and fluctuating market conditions. This article delves into the concept of untrended build yield, a metric that offers a more stable and relevant assessment for development deals.
What is Untrended Build Yield?
Untrended build yield is a metric used to evaluate real estate development projects based on current market conditions without projecting future trends. It focuses on the yield of a development project using today's market rent levels and quoted costs, eliminating the need for speculative growth rates and assumptions.
Technical Aspects of Untrended Build Yield
Untrended build yield is calculated by dividing the projected net operating income (NOI) of a fully stabilized property by the total development cost. The formula is as follows:
Untrended Build Yield = Projected NOI / Total Development Cost
This calculation provides a snapshot of the yield based on current market conditions, offering a more grounded perspective compared to IRR and NPV, which rely heavily on future projections.
Practical Application of Untrended Build Yield
Untrended build yield is particularly useful in the following scenarios:
Assessing Development Viability: By focusing on current market conditions, developers can make more informed decisions about whether a project is viable without relying on speculative future rent increases or cost changes.
Benchmarking Against Market Cap Rates: Comparing the untrended build yield to the prevailing market cap rate offers a relevant benchmark for evaluating a project's attractiveness. If the untrended build yield is significantly higher than the market cap rate, the project may be deemed more favorable.
Stabilizing Market Conditions: In volatile or uncertain markets, untrended build yield provides a stable measure that isn't influenced by unpredictable future trends.
Case Study: Practical Application
Consider a hypothetical development project with a projected NOI of $1 million and a total development cost of $10 million. The untrended build yield would be:
Untrended Build Yield= 1,000,000 / 10,000,000 = 0.10 or 10%
If the prevailing market cap rate is 7%, the untrended build yield of 10% indicates a potentially attractive investment, given the yield exceeds the market benchmark.
Comparing Untrended Build Yield with IRR and NPV
While IRR and NPV are widely used, they come with certain limitations:
IRR: This metric calculates the annualized rate of return, factoring in the time value of money. However, it can be influenced by speculative future cash flows and may not accurately reflect the current market conditions.
NPV: NPV evaluates the profitability of an investment by calculating the difference between the present value of cash inflows and outflows. It requires assumptions about future rent growth and discount rates, which can introduce bias and speculation.
Untrended build yield addresses these limitations by providing a straightforward, current-market-based assessment. It avoids the pitfalls of speculative assumptions, offering a more immediate and practical insight into a project's potential returns.
Limitations of Untrended Build Yield
While untrended build yield is a valuable metric, it has its limitations:
Short-Term Focus: It does not account for long-term changes in market conditions, which can be critical for projects with extended timelines.
Ignoring Future Growth: By not considering future rent growth or cost changes, it may overlook potential upside in appreciating markets.
Conclusion
Untrended build yield is a powerful tool for real estate developers, providing a less biased and more relevant measure of a project's viability based on current market conditions. Focusing on today's rent levels and development costs offers a practical alternative to IRR and NPV, especially in volatile markets. However, developers should consider its limitations and use it in conjunction with other metrics to make well-rounded investment decisions.
References
"Real Estate Finance and Investments," by William Brueggeman and Jeffrey Fisher.
"Commercial Real Estate Analysis and Investments," by David M. Geltner and Norman G. Miller.
"The Fundamentals of Real Estate Development," Urban Land Institute.