The Yield-on-Total Cost approach factors in all of the feasibility, cost and risk that need to be considered on a project where you’re looking to add value. This is based on a simple formula:
Total Yield or Annual Net Operating Income (=Rent-Vacancy-Operating Expenses)
Divided by Total Project Cost (=Purchase Price+ Carry Cost during vacancy + Construction/Leasing/Permitting costs)
= Target Yield on Total Cost
A vacant transitional building can’t be sold for a cap rate, but it can be evaluated using the Yield-on-Total Cost
When you’re buying transitional buildings you’re buying opportunities, such as land, to create value. In this situation, you are solving your property value or purchase price based on all of the costs, time and risk to arrive at what would be the stabilized income on that building – to arrive at your cap rate.
To set your required Yield on Total Cost, you need to have taken into account all of the risk, effort and costs based on a full business plan with all of the feasibilities calculated, to know how much you need to make a profit. It may be that you need a 6% cap rate, because you can then go and sell it to the market at a 5% cap rate, a lower rate on the same cash flow, which gives you profit.