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What's the relationship between cap rate, return on cost, and stabilized yield? This is arguably the most important relationship in real estate and most people don’t understand it at all It’s actually really simple Let’s start with the basics - The cap rate is the NOI divided by the purchase price. When you buy a deal, you buy it for an in-place cap rate - The return on cost is the NOI increase of a specific action (usually a renovation) divided by the cost of that renovation - The stabilized yield is the new NOI divided by all the costs in the deal Stabilized yield is an extension of the cap rate through the duration of the deal by adding the NOI changes to the numerator and by adding the additional costs to the denominator of the formula For example, if a property was purchased for $1MM and the NOI was $100k, the *cap rate* would be 10% ($100k NOI / $1MM PP) If you executed a $100k renovation and that increased the rents and therefore the NOI by $20k, the *return on cost* of that specific renovation would be 20% ($20k NOI increase / $100k renovation cost) Then you add the NOI increase to the numerator ($100k + $20k = $120k) and the cost increase to the denominator ($1MM + $100k = $1.1MM) Which leads to the *stabilized yield* being 10.9% ($120k new NOI / $1.1MM total costs in the deal) So you take the initial cap rate and add in each return on cost action (the new revenue gets added to the numerator and the new costs get added to the denominator) to get to the stabilized yield It’s that simple. People try and complicate RE a lot but it’s literally division Whole idea is to get your stabilized yield above the market cap rate in order to sell for the market cap rate and get cap rate compression That means that every action that would result in a ROC greater than your market cap rate, you do But any action with ROC < MCR, don’t do In the example above, if the market cap rate was the same as the entry cap rate (10%), the property would be sold for $120k / 10% = $1.2MM The total costs were $1.1MM. So your total profit on the deal would be $100k The reason the profit on the deal is so small is that the spread between your stabilized yield (10.9%) and the market cap rate (10%) is so small (only 90 bps) Typically you want to shoot for at least a 150-200bps spread between the two if you want to make good money And that’s basically it. It’s very simple. In place cap rate gets altered by every action you perform at the property (and each action has a return on cost) The cap rate + all the return on cost actions = stabilized yield Stabilized yield > market cap rate, you make money