Although the word "valuation" seems straightforward, thinking about the term will give us insight into ways of determining an accurate measure of value. The first question to ask is why someone wants to own a self-storage facility. The answer is almost always that they want the current income with a potential for growth over time and the ability to sell the facility in the future for a profit.
VERY FEW PEOPLE BUY A SELF-STORAGE FACILITY FOR PERSONAL SATISFACTION OR TO IMPRESS THEIR FRIENDS. If, for example, someone were purchasing a diamond or an automobile, the reasons to purchase and the elements of value would be much different than those for acquiring a self-storage facility. In reality, the only reason to buy a facility is it produces income--more income than could be produced at similar risks in other types of investments such as stocks, bonds, carwashes or hotels.
It is now clear the principle underlying theme of value as it relates to self-storage is the ability of a facility to generate income and compete against other facilities in its marketplace. In the valuation process, little concern is given to any characteristic of a facility that does not contribute to the production of income. To measure the value of a given site, we have to understand not only the amount of income it generates, but the nature and reliability of that income. This income stream must then be compared to other forms of real estate to determine the appropriate level of return on investment to induce buyers to purchase self-storage over other options.
A Word About Appraisals
This article focuses on the three traditional approaches to value used by real estate appraisers: 1) the income approach, 2) the comparable sales approach and 3) the cost to replace the facility. In appraisal theory, all three approaches provide the same answer to the question of real estate value. However, because of the importance of income in generating value, a great deal of focus is placed on understanding its composition and nature. As you will see, the other two appraisal approaches are also important in determining and confirming value.
The Source of Value
In self-storage and most other income producing real estate, the source of value is either current actual income or the reasonable potential of future income. The potential future income can come in the form of increased actual income or the proceeds from a sale of the property. Income seems like an easy word to understand, but in determining real estate value, the term income has several meanings.
For purposes of determining value, the definition of the net operating income (NOI) is important. NOI is merely the product of subtracting the operating expenses from the operating revenues. Operating revenues are those generated from the day-to-day operations of a facility, such as rent, reasonable late fees, lock sales, box sales and auctions. They are not proceeds of sales of equipment or partnerships in the property, insurance-claim payments, proceeds of refinancing or other nonreoccurring income.
The key to understanding operating revenue is it occurs in the ordinary course of the primary business on a recurring basis. In the case of self-storage, it takes the form of rent from tenants. Other revenue can be included only if it is ancillary to the main business of renting space. It will not be considered real estate in valuing the project if it is more than ancillary to primary business. For example, if box sales contributed 60 percent of the total revenue of a facility, that income would be viewed as being of a business other than the primary real estate.
Operating expenses used in valuation are most interesting for what they do not include: interest, depreciation, large equipment costs or amortization on a loan. Also, for valuation purposes, operating expenses do not encompass any personal expenses. However, they may include some things not currently being paid for by the facility, such as management fees. The reason for including management fees, even if they are not currently being paid, is the next owner would have to pay them or provide the service himself.
Operating expenses used in valuing a property can also include increased property taxes caused by the sale of the property. This is because the new buyer will have higher tax expenses (and, therefore, less income) than the current owner. The expenses included are the usual recurring costs such as labor, utilities, legal fees, insurance, advertising, repairs and telephone fees.
If you subtract operating expenses from operating revenue, the product is NOI. For example, assume the operating revenues are $342,000 and the operating expenses are $120,000 (about 35 percent) for a resulting NOI of $222,000. It should be noted that, except in extraordinary cases, the buyer would only consider "trailing income," i.e., the last 12 months of actual NOI, not projections of rent increases in the future.
NOI is not cash flow. Cash flow is the NOI minus the debt service, the principal and interest on any loans. Cash flow is not a component of valuation; however, it is a very important component in calculating the return on equity, which is the ratio of the debt service to the amount of equity required after placing a loan on the property.
How Much Will the Buyer Pay for the Income?
Now that NOI has been calculated, it must be determined what reasonable buyers in the marketplace will pay for the level of NOI the facility has available. This relates to the buyer's perception of risk and his requirement for a return on investment. The market value of the property is the capitalized value of the income stream that can be reasonably expected to be achieved in the market.
How is the expected rate of return determined for a market? Appraisers use comparable sales to help determine value. In this case, previous sales of self-storage are examined to determine what rate of return buyers demand to purchase a given facility. For example, a comparable sale may have been a first-class project in a large metropolitan area with an NOI of $160,000 and sales price of $1,641,000. This would indicate the buyer required a 9.75 percent return on NOI. Another sale of a class-C facility in a small declining industrial town sold with a $120,000 NOI and a sales price of $1,043,000 , indicating the buyer was willing to buy only if he could achieve a return of 11.5 percent on this property with more risk and less potential for income growth.
After looking at many such sales, it becomes clear the market for selling self-storage facilities exists almost exclusively at rates of return of between 9 percent for the very best properties and 11.5 percent for the properties with the most risk and least quality. The chart below shows some recent sales. Because there is a supply of buyers and sellers willing to conduct business at these rates, it is very rare to find a sale outside that range.
For example, if a seller will not sell for the market rate of return for his property, another will sell for that price, satisfying the buyers in the market. The fact most self-storage facilities are bought by current owners already familiar with the business means the range of market values is very narrow; they know the risks and rewards of self-storage.
Now it's time to calculate the value of the self-storage facility used in the above discussion of NOI. The NOI in the example was $222,000. Now that we know the range of returns buyers expect (and at which other sellers are willing to sell), the value can be determined by learning just a bit more about our hypothetical property.
|Occupancy (last two years)||95%-100%||90%-95%||<90%|
|Rates (last two years)||Continuous Rise||Steady||Falling|
|Size||>45,000||30,000 to 45,000||<30,000|
|Competition (3-mile radius)||None||One||More than One|
|Surrounding Area||Growing Metro||Large City Rural|
|Density (5-mile radius)||>200,000||100,000 to 200,000||<100,000|
|Traffic Counts||>25,000||10,000 to 25,000||<10,000|
|Median Household Income||Above Average||Average||Below Average|
|Manager||Full-Time (Living on Site)||Full-Time (Living on Site)||Other|
|Records (last three years)||Computerized and Professionally Audited||Computerized||Other|
|Computer System||Computers and SS Accounting Software||Computers||None|
|Construction||Concrete or Brick||Combination Brick and Metal||Metal|
|Maintenance||Pristine||Little Deferred Maintenance||Modest Deferred Maintenance|
|Security||Full Gate and Card Access||Full Gate||Other|
|Access||Very Direct||Clear, but Not Direct||Difficult|
|Visibility||Can See Sign and Facility||Can See Sign and Entrance||Can See Sign Only|
|Source: Argus Real Estate Inc., Denver|
First, assume the property is new in a fast-growing area. It has low vacancy and good construction. If this property compares favorably to the one that sold for the 9.75 percent return, the NOI divided by the rate of return would be $2,256,000. Now assume the sample project closely resembles the project in which the buyer required an 11.5 percent return. The value would then be $222,000 divided by 11.5 percent, or $1,930,000.
Real estate professionals refer to these market rates of return as capitalization rates, or simply cap rates. The accompanying chart shows some characteristics of projects relating to various cap rates. It should be used as a general guide in developing values. Clearly, there are other adjustments to be made in calculating values of self-storage facilities, such as a deduction for excessive deferred maintenance or the economic consequences of a high-rate loan that must be assumed. Positive adjustments can be made for extra land or rental rates that are grossly below market.
The Last Approach to Value
As you may recall, there is a third way to look at value: the cost-to-replace method. This method simply attempts to develop the current costs to replace the project today. Theoretically, it should produce roughly the same value as computed in the above analysis--when the appraiser makes the right adjustments. However, it is more than an exercise in good appraisal to make this comparison.
In today's market, there are a number of projects for which the value computed on income capitalization significantly exceeds the replacement cost of the project. The situation provides an incentive for developers to build additional units that could cause rental rates to decrease. Overbuilding continues to be the most significant risk to self-storage values. Sophisticated or well-represented buyers always make a calculation of replacement cost and make an adjustment to the NOI of a facility for sale if there is a significant potential exposure to overbuilding.
Lenders, in their appraisals, are becoming even more sensitive to replacement costs and are often using them as an upper limit to loan value. While not a rule, it appears when values derived from income capitalization exceed replacement-cost valuations by more than 15 percent, adjustments to the income valuation become necessary to consider.
How to Value Your Property
The above review will provide most of the mechanics to help you get to a preliminary or ballpark value for a facility. However, you have to be impartial when making a judgment call regarding income and expenses and compare your project to the chart to get an estimate of the cap rate.
Then talk to a professional--a broker or an appraiser--and ask him for an estimate of value. Talk to him in detail about how he developed his value and see if you concur. Unless you fully understand all the assumptions he uses and agree with them, you should hire an appraiser to do a complete appraisal. Such assurances will allow you to enter the sales process with confidence you are pricing the property correctly. The time to be sure is before you list the facility. Understanding and setting the value of the property is the single most important step in the selling process.
Michael L. McCune has been actively involved in commerical real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real estate consulting, brokerage and development company based in Denver. In January 1994, he created the Argus Self Storage Real Estate Network, now the nation's largest network of independent commercial real estate brokers dedicated to the buying and selling of self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.