By Michael McCune
After attending many conferences and having fielded questions from literally hundreds of buyers and sellers of self-storage all over the United States, we have begun to realize that there is a real communication problem in how specific terms are defined regarding the sale and valuation of self-storage facilities. With this in mind, we decided to clarify a few specific terms that are used most often.
All income, which includes rentals, sales, interest, late fees and truck rentals, if applicable, minus all expenses, which includes all operating expenses, depreciation and interest.
This is an "official" accounting term that is used by CPAs and the IRS, but not much by the rest of us when trying to understand the business operations.
Net Operating Income (NOI)
Actual income minus all operating expenses for facility (but not debt service, depreciation or interest.)
Ideally, this number tells us how well the property is doing just from operations--not from financing or from accounting requirements. This is the first number a potential buyer will look at when he reviews the financial statements. One hundred percent of the time, a potential buyer will mentally adjust this number to reflect his interpretation of the validity for some of the expenses shown on the statement. For example, sellers might not pay themselves a salary or off-site management fee, as they manage the property themselves. The potential buyer could be an absentee investor, and need to hire not only a manager to run the property, but also pay a third-party management company to work the books of his whole portfolio. He will adjust the NOI to reflect this added expense to his analysis of the property.
Actual income minus operating expenses and debt sevice.
This term is best described as the "cigar box" number. This is the amount you would have left in the cigar box if all the cash income went in it and all of the expenses were paid in cash out of the box. I think this is the most important number to our spouses and kids because it represents "spendable" income before your income taxes are paid.
Capitalization Rate (Cap Rate)
A cap rate is the result of converting an income stream into a single capital value or an estimate of present worth (value). The capitalization rate is derived from consideration of marketability, liquidity preference, time preference and risks associated with uncertainty of the future.
Everybody uses it--what is it? Some people would say that real-estate brokers use the term to just look smart. And while anything along those lines would be helpful, the term is meant to be a short-cut to discuss and analyze relative value in the marketplace for competing investments. The term "cap rate" encompasses the potential return to the buyer on a perfect property that includes factors such as risk, market cycle, level of maintenance, location, etc.
Let's assume that a brand-new, fully leased property with all the bells and whistles in the best area of town required a 10 percent return to the investor to induce him to buy the property. The cap rate would be 10--not 10 percent, just 10.
Another property of lesser quality and not exactly in the best location is also for sale. Would the buyer be willing to earn only a 10 percent rate on this property when he could buy the class A property for the same rate? Of course not. He would want a higher return because of the risk and quality of the property. After a careful analysis of competition and the market, the buyer decides that he should earn 11.5 percent on the older property to compensate for the differences between the new, class A property and the older property. That would mean that the valuation would be based on say an 11.5 cap. The seller of the class B property would need to be willing to accept the buyer's analysis and live with a lower price per foot and sales price.
The term is obviously very subjective, and the exact interpretation may depend on whether you are a buyer or seller. But it is a convenient way of lumping a lot of intangibles into one number. Currently, cap rates for self-storage facilities around the country range from 9.5 to 12, with most falling into the 10 to 11 range.
What your property is really worth for financing or a sale.
Appraisers will tell you that market value is determined by comparing three approaches to value: cost to replace or rebuild, market comparable sales, and the capitalized value of the income stream from the property. Oddly enough they are right, but for most buyers and sellers, more reliance is put on the capitalized value of the income stream. To obtain an estimate of value you can take the NOI and divide by a cap rate in the 11 range, assuming there are no extraordinary items related to the property. Of course, there are many other factors that contribute to the ultimate value and thus, checking the indicated value of a property with a professional broker or appraiser should help determine the final value.
Mike McCune is president of Argus Self Storage Sales Network, a nationwide network of brokers specializing in self-storage properties. Based in Denver, Mr. McCune may be reached at (800) 557-8673.