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Analyzing UYOC and WACC for Better Investment Decisions in Commercial Real Estate

Unleveraged Yield on Cost vs Weight Average Cost of Capital

Unleveraged Yield on Cost (UYOC) is a great measuring stick to see how a property performs without the benefit of debt. I wrote another article on this in more detail here, but essentially it's calculated by dividing the property's net operating income (NOI) by the total cost of the investment (purchase price plus capital improvements). Make sure that your total costs include all of the first year out of pocket expenses. UYOC is used to evaluate the profitability of a project irrespective of the financing structure. It gives a clear picture of the project's efficiency and potential returns based solely on its operational performance. Many projects will mask a project's deficiencies by leveraging the property and boosting returns. Once I have this number, I will want to compare it to two others metrics.

The Weighted Average Cost of Capital (WACC) represents the average rate of return a company is expected to pay its security holders to finance its assets. In commercial real estate, it's a blend of the costs of equity and debt financing, weighted according to their proportion in the overall capital structure. WACC is crucial for determining the minimum acceptable return on an investment, considering both equity and debt financing and is a key metric in investment decisions and valuations.

UYOC reflects the risk associated solely with the property's operational aspects, while WACC incorporates both operational and financial risk (due to leverage). With this in mind, I want to make sure that the additional leverage risk is less than the operational returns. Or said another way, I want the properties operations to pull its weight against the leverage risk. Therefore, all things being equal, if the UYOC is greater than the WACC, this points to a potentially attractive investment.

Another UYOC check is to compare it to the market capitalization rate for like-kind properties. This becomes a bit more subjective since true cap rates are difficult to determine, but the idea is to understand the spread between the two, as illustrated:

UYOC and WACC serve different but complementary purposes in CRE investment analysis. While UYOC offers a pure view of a project's operational efficiency, WACC provides a holistic view of the cost of capital considering both equity and debt. Comparing these metrics helps in understanding both the operational efficiency and the financial viability of a real estate investment.

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