Inside the Investor’s Mind
|Copyright 2014 by Virgo Publishing.|
|By: Dale Eisenman|
|Posted on: 02/01/2007|
What determines the value of a self-storage facility? The answer is income—current and future. It’s what drives the value of all investments, including commercial real estate. People seek investment vehicles they believe will provide a risk-weighted return superior to alternatives on the market. See your facility this way, and you’ll be positioned to maximize its value.
All investments carry some risk of loss. Some are relatively safe, such as bank CDs and U.S. Treasuries. Corporate bonds are riskier, so they must offer a greater return to compensate for the investor taking a greater gamble. So goes the relationship between perceived risk and potential rewards.
Investors are in the business of determining the appropriate return for the risk they assume. Much like betting odds associated with sporting events, the offered returns of financial investments must be adjusted in accordance with the capital attracted. If a bank doesn’t draw enough deposits by offering a 1.5 percent return on checking accounts, it may raise its rate to 1.75 percent.
As an example, would you rather own an investment offering a 10 percent return or a 5 percent return? Naturally, you would gravitate toward the higher number. But what if it had a 50 percent chance of dropping by one-third, while the lower-return option promised near-zero risk of loss?
Some investors seek safe investments with lower rewards. Others are willing to face greater risk in exchange for commensurate returns. The same analysis is applied to commercial real estate as a potential investment.
The first step in determining the potential return of a self-storage facility is gauging its annual income after all operating expenses. In other words, the investor has to establish the property’s net operating income (NOI).
The following formula can be used: Take the facility’s gross potential income (GPI), which is the amount generated at 100 percent occupancy. Subtract vacancy and credit losses to get the gross effective income (GEI). Finally, subtract all operating expenses and you’ll have the NOI. Operating expenses include real estate taxes, payroll, utilities, repairs, maintenance and management.
Cap Rates and Returns
Once an investor determines a property’s income, he can calculate its value by applying a desired rate of return—called a capitalization rate. Let’s say an investor desires a rate of return of 8 percent. That means he would be willing to pay an amount equal to the income generated by the property, divided by 8 percent.
Let’s say a self-storage facility has a gross potential income of $500,000 annually and is 85 percent occupied. To keep the analysis simple, the GEI is assumed to be equal to 85 percent of the GPI, or $425,000. If operating expenses are $175,000, then the NOI is $250,000. Therefore, if an investor seeks an 8 percent return, he would be willing to pay $3.12 million for the property, which is $250,000 divided by 8 percent.
To sum up, a self-storage property with an NOI of $250,000 will have a value of just over $3 million at an 8 percent cap rate.
Risk and Rate
But what decides the appropriate cap rate? In part, it’s the rate an investor decides is appropriate to the investment’s perceived risk. The investor has to consider whether the self-storage property will continue to generate the calculated NOI: The greater the likelihood, the lower the risk.
If a facility is newer and located in a growth area, the risk of loss is relatively low. Therefore, the cap should be correspondingly low. On the other hand, if the store is experiencing falling rents and occupancy, the risk would be higher as would the appropriate cap rate.
The investor also must weigh the acquisition of a self-storage property against alternative investments. He may decide it’s wiser to invest $3 million in a T-bill unless the self-storage property offers a high-enough return to justify the increased risk. Self-storage competes not only with other types of commercial real estate, but with alternative investment vehicles.
Likewise, a seller may determine he’s unwilling to sell unless the amount offered is great enough to compensate for the property’s value. He must look at expected future income vs. perceived risk.
The market determines at what cap buyers will buy and sellers will sell. If investors believe they need a 10 percent return, but sellers want a value equal to an 8 percent cap, no transactions will take place.
Historically, caps for self-storage have moved in direct relationship to long-term interest rates and perceived risks. In the last few years, our industry has enjoyed low, long-term interest rates and a reputation as a solid earner.
How to Increase Value
Would you like to enhance the value of your self-storage property? The key lies in increasing NOI through a combination of minimizing operating expenses and maximizing revenues. Let’s focus on the effect of improved revenue through rental rate increases.
Assume our self-storage facility with the $500,000 in gross potential income has 500 units. The average monthly rental rate would be $83.33 ($83.33 x 500 = 41,665 x 12 = $499,980). As shown, at 85 percent occupancy it generated a NOI of $250,000. What would happen if rents are increased just $5 per unit per month or about 6 percent? At 85 percent occupancy the annual gross effective income would increase from $425,000 to $450,483.
If we assume the operating expenses stay the same, the NOI increases from $250,000 to $275,483. But what happens to the value of the self-storage facility? If we use the same 8 percent capitalization rate, it increases from $3.12 million to $3.44 million, about 10 percent. So a modest increase in monthly rent can generate a significant increase in the value of the property.
Rental Rates and Occupancy
When I discuss the concept with owners and managers, they’re often concerned occupancy will fall if rents rise. Tenants’ sensitivity to rent increases will vary from market to market. However, it’s possible to calculate what kind of drop in occupancy would be financially acceptable.
If a $5 monthly hike resulted in occupancy dropping from 85 percent to 81 percent, would it be worth it? At the new rental rates, you would still achieve a gross effective income of $429,283—an increase of more than $4,000.
Only the owner and operator of a facility can evaluate the impact of higher rental rates on occupancy. But properly managed, they can have a significant impact on value. See your property as an investment vehicle competing with alternative ventures, and you’ll be better prepared to maximize its value by smart management of revenue and expenses.
Dale C. Eisenman, president of Midcoast Properties Inc., is a licensed real estate broker in North Carolina, South Carolina and Georgia. He specializes in the self-storage industry as an investor and is a member of the Argus Self Storage Sales Network. Mr. Eisenman is also president of the North Carolina Self Storage Association. For more information, call 843.342.7650; e-mail email@example.com; visit www.midcoastproperties.com.