Return on Cost (ROC)

How to Calculate Return on Cost (ROC)

The return on cost (or “stabilized yield”) is a back-of-the-envelope method to determine if a real estate project is worth pursuing from a risk-return standpoint.

Conceptually, the return on cost (ROC) is the pro forma, post-stabilization cap rate once all construction activity and property renovations are fully complete, with the rental property units leased at the market rate.

The practical use-case of the return on cost (ROC) metric is to analyze the viability of a capital-intensive property investment, where the underlying strategy to achieve a profitable return is either through a value-add project or a development project.

• Value-Add Project → In the value-add strategy, the real estate investor renovates and improves an existing property, with the property then warranting an increase in its rental rate (and at a higher margin per lease).
• Development Project → On the other hand, a development project is a long-term investment in which the property is built from scratch (“the ground up”).

The question answered by measuring the return on cost is, “What is the implied annual yield of a property post-stabilization on a total project cost basis?”

The commonality between the two strategies is that there is a period post-acquisition during which the property units are not leased to tenants (and are not generating rental income).

Hence, real estate development firms and value-add investors prioritize return on cost to guide their investment decision-making process, since the future income-generation potential of the stabilized property is factored into the metric.

To calculate the return on cost (ROC), the net operating income (NOI) of the property at stabilization is divided by the total project cost.

• Stabilized Net Operating Income (NOI) → The stabilized NOI is the profitability of a property before non-operating costs like financing costs and income taxes are deducted.
• Total Project Cost → The project cost, or development cost, is the total of all spending post-acquisition as related to capital expenditures (Capex), such as construction costs and renovation fees.

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Return on Cost Formula (ROC)

The formula to calculate the return on cost is the stabilized NOI of the underlying property divided by the total project cost.

Where:

• Stabilized Net Operating Income (NOI) = Effective Gross Income (EGI) – Direct Operating Expenses
• Total Project Cost = Purchase Price + Development Cost + Renovation Cost

To reiterate, the NOI must be on a post-stabilization basis — otherwise, the metric would not be meaningful, as the property would not yet be producing rental income.

In the context of a development project, the purchase price component is related to acquiring the land on which the property will be built. But for a value-add project, the purchase price is the cost incurred to acquire the existing property.

Furthermore, the development cost component is inclusive of any costs that pertain to construction, renovations, and related capital expenditures (Capex).

With that said, the total project cost will, of course, be substantially greater for a real estate development project compared to that of a value-add project.

Why? The stabilized yield on a value-add project focuses on the potential rate of return with respect to the cost of improvements — e.g. renovation costs and rehabilitation costs — rather than construction costs.