By Burt Gay
Net-Operating Income Determines Value
As with any other investment, the value of your self-storage facility depends upon its income--not its number of units or even its square footage. If you doubt this, look at the graph below. Multiply net income (found along the horizontal axis) by roughly 10 and you will see the sales price per square foot (on the vertical axis). Net operating income of $2, $4, $6 and $8 per square foot is equivalent to $20, $40, $60 and $80 per square foot, respectively, of selling price. Notice how many self-storage facilities cluster around $4 per square foot of income and $40 per square foot of value. In fact, the average self-storage facility sells for just under $40 per square foot according to the Self Storage Almanac.
How does net income per square foot relate to your self-storage facility? If you rent 10-by-10 units for $50 per month, that is equivalent to $600 per year or $6 per square foot. If your expenses run one-third of collections, a 40,000-square-foot facility earns $4 per square foot and is worth about $1.6 million.
How Do You Calculate Net Income?
An income statement from a seller usually shows actual historical income. However, it may show what income would have been if circumstances had been better. There are no generally accepted accounting principals or rules a seller cannot break in presenting income.
Buyers and sellers create different income statements for the same facility because of timing and operating differences. Buyers will own facilities in the future when expenses may be different from the past. For example, property taxes may rise if the sale of the facility triggers a new tax assessment. Buyers and sellers also incur different expenses depending on how they operate the facility. For example, local sellers may personally supervise their on-site managers while out-of-state buyers or lenders must hire management firms for this purpose. Buyers may charge different late fees or may shut down truck rentals. One of my sales fell apart when a buyer assigned no value to $31,000 of annual truck-rental income that he planned to shut down.
Chart 2, "Typical Self-Storage," demonstrates an example of two different income statements. It is an average facility (40,000 square feet) with average rents ($6 per square foot) and has the potential to collect $240,000 per year.
Note 1. Truck-rental income may be reduced or eliminated because truck-rental distracts managers from self- storage and may disappear when the manager leaves.
Note 2. "Other" income (late fees, box sales, locks, etc.) may be reduced to some arbitrary percentage of revenues that a particular buyer historically collected, e.g., 6 percent.
Note 3. Vacancy expenses may be increased to market levels--typically 10 percent, although vacancy on a national basis averages 12 percent.
Note 4. Property tax may be adjusted upward to equal the sales price times the tax rate.
Note 5. Off-site management expenses of 6 percent may be added to hire a management firm to oversee the investment and account for the owner's time if he performed this function himself.
Note 6. Repairs and maintenance expenses may be normalized to $.10 per square foot to reserve funds for repairs and preclude owners from increasing income by deferring maintenance.
Note 7. Capital improvements expense of $.10 per square foot may be added to fund major improvements that a facility will eventually require to remain competitive.
Notice that both income statements exclude interest expense so that facilities purchased with debt can be compared to ones purchased for all cash. Also notice there is no depreciation expense. However, lenders and buyers add reserves for repairs and capital improvements that offset the absence of depreciation. In this example, the buyer has eliminated $40,000 of revenues and added $30,000 of expenses. He has cut net income by $70,000, and his perception of value may be $600,000 to $700,000 below the seller's. Unless the buyer, seller and lender have similar perceptions of income and value, there may be no sale.
Improve Your Income
Because every dollar of current income is magnified into almost $10 of sales price, it is worthwhile for a seller to maximize income before marketing begins. Income that is created before the marketing package is prepared is "current" income, while prospective income (which is more tenuous) is relegated to a "proforma" (assumed) income statement.
Why does this matter? Sellers often say, "My rents are below market, but you can raise them." Buyers then reply, "If that is really true, why didn't you raise them yourself?" One self-storage owner retained a prominent brokerage firm to sell his facility without success for a year. He then tried to sell it at auction without success. Then he tried to sell it himself. As a last resort, he gave me the listing and it went under contract at full price on the first day of marketing. How? I got him to raise rents, recalculated income and showed a higher cap rate. Unlike the stock market, which looks forward, real-estate buyers generally look back and give more credence to actual or current income. Here are some actions to consider:
- Owners should pay full rent for any storage units they have been using for free. It doesn't matter that the units would have been vacant and not brought in any rent. An owner who "saved" $3,000 per year by using six free units may have lost $25,000 in sales price. Buyers look at collections deposited in the bank. An owner who needs cash can always withdraw his money after making the deposit.
- Reduce discounts to existing customers who are paying below your current list prices. If some customers threaten to leave, restore their old rates.
- Raise rental rates if occupancy exceeds 90 percent. Since buyers disallow occupancy above 90 percent, you should maximize income from the 90 percent occupancy they will allow.
- Utilize setback spaces by adding RV parking or portable storage. Portable storage can be attractive due to tax advantages of rapid depreciation.
- Install truck rental if there is none. Truck rental creates its own income. As a byproduct, it also brings new storage customers, which helps occupancy and rents.
- Increase "other" income by raising late fees and selling boxes, locks, insurance, etc.
- Cut expenses. Appeal property-tax bills, etc.
What Cap Rate Is Appropriate?
Cap rate is an investor's yield, i.e., net-operating income divided by the sales price. Cap rate is the inverse of the price/earnings ratio used in the stock market, except that earnings are calculated differently. Just as price/earnings ratios vary over time by company, cap rates vary by time, geography, quality and risk. Investors expect higher yields for small facilities (under 40,000 square feet) and ones in bad locations (poor visibility and access). They pay premiums for good demographics: rapid population growth, high density (over 100,000 residents in five miles), high household income (associated with high rents) and a high concentration of apartments. Apartment renters need storage because they lack space and move more frequently than homeowners. Buyers pay a premium if there is vacant land for expansion, especially if restrictive zoning presents potential competitors with a barrier to entry. According to the Self Storage Almanac, the average cap rate for approximately 200 transactions is 10.5 percent (although the Almanac incorrectly calculates it at 12 percent).
Financing Affects Value
Theoreticians argue that financing does not affect value. Look at the counterexample presented in chart 3, "Financing Affects Value," and see if you agree.
In this example, financing that is only 2 percent lower in interest rate (8 percent vs. 10 percent) earns 50 percent more cash after debt service. Many investors base their purchases upon "cash-on-cash" yield, which is net-operating income after debt service divided by the down payment. Cash-on-cash is an investor's annual "cash-in" divided by his initial "cash-out" (down payment).
Sellers can raise their sales prices by offering attractive financing. If a seller offers a $200,000 second loan at 10 percent interest for five years, the buyer's cash flow drops by $20,000 per year ($200,000 x 10 percent). However, the cash-on-cash return rises to 20 percent as the down payment drops by $200,000 ($45,000/$226,000 = 20 percent). More importantly, many investors who have only $250,000 to invest (and cannot afford other large facilities) will make offers and bid up the price.
A Good Broker Affects Value
You can buy a stock over the Internet for a mere $12 commission, but a real-estate broker may charge you $100,000. Why? Real estate is not a commodity with exact specifications like books, computers, stocks or automobiles that can be readily compared and purchased over the Internet. Real-estate income statements lack generally accepted accounting principals enforced by a regulatory agency and, therefore, lack comparability. How can you compare cap rates when the income statements they are based upon are prepared differently? Buyers focus on reliable sources of information to waste less time.
If two mathematicians are given a problem and one fails to solve it, there is no amount of money--no matter how small--you would want to pay the one who failed. One-third of listed properties do not sell at all and are like the unsolved problem. Similarly, if you hire an attorney and he loses your case, he has a negative value. Many self-storage properties sell, but at prices below their worth. Some sellers who will not list their property with a broker will then accept an offer from a buyer represented by one and watch helplessly as the broker immediately resells the property at a huge profit. Even self-storage appraisals offer no assurance of fair market value. As an example, I sold one self-storage facility at $2,104,000 just after it had been appraised at $1,700,000 because the appraiser was just wrong.
The photograph above demonstrates the importance of perception. Do you see a metro-Atlanta dump site? If so, this illustrates the rule that "believing is seeing," not vice-versa. You are actually looking at a drive-in volcano on the island of St. Lucia. You believed and, therefore, perceived it differently. Good brokerage does the same thing--and affects value.
Burt Gay is a self-storage broker at Marcus & Millichap, the nation's largest investment property brokerage firm. Last year the company's 550 brokers sold more than $5 billion of real estate and, during the decade, sold $200 million of self-storage. In the first eight months of 2000, Mr. Gay has personally sold 14 self-storage facilities worth $20 million. Several of his sales included self- storage facilities in rent-up or in overbuilt areas where his prior experience as a CPA enabled him to structure unusual financial arrangements.
Mr. Gay has been a popular speaker at numerous self-storage trade shows and for the Georgia Storage Owner's Society. He graduated from Princeton University, received an MBA in finance from Wharton and became a CPA at Coopers & Lybrand. Last year he received the Certified Commercial Investment Member designation. For more information, visit www.mmreibc.com.
|Truck Rental||$20,000||$10,000 (Note 1)|
|Other||$25,000||$19,000 (Note 2)|
|Less: Vacancy||-$0||-$24,000 (Note 3)|
|Property Tax||$12,000||$21,000 (Note 4)|
|Off-Site Management||$0||$15,000 (Note 5)|
|Repairs & Maintenance||$2,000||$4,000 (Note 6)|
|Capital Improvements||$0||$4,000 (Note 7)|
|Net Operating Income||$225,000||$155,000|
Financing Affects Value
|10% Interest||8% Interest|
|Net Operating Income||$189,000||$189,000|
|Less: Debt Service||-$146,000||-$124,000|
|Cash Flow Before Tax||$43,000||$65,000|
|25% Down Payment||$446,000||$446,000|
|Cash In/Cash Out||$43,000/446,000||$65,000/446,000|