In the competitive world of commercial real estate, self-storage properties have emerged as a popular and lucrative investment option. To help determine whether to pursue a proposed project, developers and investors use a wide range of profitability metrics, such as equity multiple, cash-on-cash return and internal rate of return, among others. There’s one, however, that tends to be underrated and underused: return on cost (ROC).
ROC is often referred to as “gross margin.” It measures the percentage of profit left after accounting for the cost of a project. In the context of self-storage, it’s the incremental value created by an investor through the execution of a business plan. In this article, I’ll discuss how to calculate ROC and why it’s particularly valuable in the decision-making process.
To calculate the ROC of a self-storage development, we need two essential variables: the stabilized valuation of the property and the total project cost. Stabilized valuation represents the fair market value of the facility once it reaches stabilized occupancy, typically 85% to 90%. It considers factors like location, market demand, size and construction quality. The steps to calculate this value are:
- Determine the annual net operating income (NOI), which is the income generated by the property after deducting all operating expenses but before deducting debt-service payments.
- Determine the capitalization (cap) rate. This is the rate of return an investor would expect to earn on the property, given the risk involved.
- Divide the annual NOI by the cap rate.
Market cap rates can be challenging to find. In most jurisdictions, the sale price of a property is public record, but its NOI is known only to the owner or anyone with whom they share it. If you aren’t familiar with the prevailing cap rates in a particular market, start by talking with a local real estate broker or appraiser, or conduct research using one of the industry’s many market-data resources.
The total project cost comprises all expenses incurred during the development process, from the purchase price of the land to hard construction costs to soft costs such as legal fees and permits. For an accurate estimate, also include contingencies and financing costs as well as any cash reserves you allocate.
Once you have your two values—stabilized valuation and total project cost—the ROC is calculated by subtracting total project cost from stabilized valuation, then dividing that number by the total project cost. For example, let’s say you’re considering a self-storage project with the following breakout:
- Initial purchase: $2,250,000
- Closing costs and fees: $67,500
- Capital expenditures: $175,000
- Cash reserves: $50,000
- Total project cost: $2,542,500
In your pro forma, you estimate that once you’ve completed the business plan, you’ll generate NOI of $20,000 per month. From talking with a few local real estate brokers, you’ve learned that the prevailing cap rate for self-storage facilities like yours in the market is 7%. Therefore, your stabilized valuation is $3,428,571 ($240,000 NOI divided by 7%). To calculate the ROC:
- $3,428,571 - $2,542,500 = $886,071
- $886,071 / $2,542,500 = .3485
- .3485 x 100 = 34.85
Essentially, by executing your business plan for the property, you will have increased its value by 34.9%.
ROC vs. Entry Cap Rate
ROC is a more useful real estate investment metric than entry cap rates for several reasons. First, it offers a more comprehensive picture of a project’s financial performance, highlighting the incremental value created after accounting for direct project costs. This allows you to gauge the potential profitability more accurately.
In addition, ROC enables you to evaluate the efficiency of a project, including how effectively costs are managed and the resources used. This allows you to better assess the level of risk associated the development and make more informed decisions.
In contrast, entry cap rates are a measure of the initial rate of return on a real estate investment and don’t consider future changes in income or expenses. While cap rates can help you quickly compare opportunities, they might not provide a complete understanding of a project’s long-term potential. Since market conditions and investor expectations can impact cap rates, relying on that number solely can lead to a skewed perception of financial performance. ROC, on the other hand, allows for a more in-depth analysis of a project’s financial health, making it a more valuable metric to optimize an investment and mitigate risk.
What’s a ‘Good’ ROC?
So, what constitutes a good ROC? Well, as with most things in real estate, it depends. Each self-storage project and investor will have a different requirement based on their goals and tolerance for risk. Consider:
- What are your investment goals? If the objective is to create significant increased value and exit as quickly as possible, then a high ROC would be required.
- What’s the level of assessed risk? If an asset is already stable and performing nicely—and any value you create will just be gravy—then a lower ROC may be acceptable.
- How much time and effort are required? If the project is ground-up development, an expansion or entails a significant capital expenditure, you may need a high ROC to justify its pursuit.
If I accept a project with an ROC of 10% to 15%, it should be a stabilized asset with a low-risk, low-effort business plan. If I’m evaluating a ground-up self storage development or an expansion play, I want to see an ROC of 30% or higher. I need to make sure the property can still be profitable if costs unexpectedly go up or unforeseen market conditions negatively impact the stabilized valuation.
One Piece of the Puzzle
When it comes to making investment decisions, you should never rely on just one metric. For each project, various data points will be relevant. Still, it’s worth noting that ROC tells a story that other metrics like entry cap or internal rate of return overlook. Always consider which numbers are most applicable to your particular scenario. I’m confident that ROC will often be on that list!
Jon Allen is self-storage managing partner for PassiveInvesting.com LLC, which has invested in commercial real estate assets since 2013. The firm specializes in express car wash, hotel, multi-family and self-storage properties. Jon is a certified public accountant with 13 years of real estate finance experience. He focuses on the underwriting, development and capital-markets functions of the company’s self-storage assets. To reach him, visit his profile on LinkedIn.