In the February issue of Inside Self-Storage, I published an article titled "Valuation of Self-Storage Facilities." Since then, I've received many calls from people interested in financing, real estate tax issues, estate valuation or selling. Most are looking for a ballpark value for their facilities for planning purposes. Several have asked for a simple worksheet they can use to develop a value range.
Appraisal and valuation are a professional art, and while mechanical number manipulations are a very important part of the process, there is also a large measure of real estate judgment and experience in developing a precise value. I cannot impart such a judgment in a brief worksheet, but I can give you the basics of the number-crunching mechanics that may get you into the general vicinity--I can also point out some anomalies in valuation that can take you right out of it. Since few of these exceptions are easily understood or straightforward to evaluate, I will simply note them and encourage you to seek further advice if they exist in your facility.
It should also be noted a true appraisal takes an in-depth look at value, not only based on income, but from a cost and a market-sales basis. The cost-basis method looks at the price of replacing the facility in the particular market. The market-sales approach compares the values actually achieved in the market by similar facilities in recent sales.
Without reconciling the values from each of these methods, one cannot be sure the right value for the property has been identified. It is a complicated process requiring expertise and experience of a professional active in the business. Regardless of your need for the information, shortcuts to developing the right value can lead you to erroneous conclusions. As you follow the steps outlined in this article, you must be aware the answer number-crunching provides is merely an estimate of potential value and may be subject to a wide range in actual figures.
With all of the caveats stated and the exceptions to be noted hereafter, the following exercise is designed to show you how cash flow largely determines the value of a facility and the potential sensitivity of value to various operating results. As you work through the numbers, try changing some--such as dropping rates 5 percent or occupancy 7 percent, or raising real estate taxes by 20 percent--and see what happens to the values. You will learn why good operations are often the most important factor in creating value. It is important to remember a buyer determines price and is really buying income, not "bricks and sticks." The iron rule of value is, "If there is no income, there is no value; if there is less income, there is less value."
The "worksheet" provided at the end of this article is where you will write all numbers and develop a value range; but first you have to determine where you will get the numbers and how to use them. A good place is your most recent tax return or your last 12 months of operating statements. With this information in hand, you are ready to begin your investigation and fill in the worksheet, carefully reading the admonitions in the instructions.
Since self-storage is a seasonal business, you must consider a full 12 months of actual business rather than extrapolating the best three. An appraiser would also look at the trend over the last few years to see if it is declining and, if so, might adjust the final price or capitalization rate. If there is a significant vacancy--say more than 15 percent of potential rents--there may also be an adjustment.
Very few appraisers will count revenues in excess of 90 percent of potential rents, except in very unusual circumstances. When evaluating vacancies, it is very important to compare the actual rent received to the potential and not just the physical occupancy. It is very possible to be 92 percent leased physically and only 80 percent occupied economically. If there are many (or even one) new facilities nearby that are about to open or in lease-up, all bets are off until it is very clear rates and occupancies will remain stable. This is a good place to test the sensitivities by changing the revenue to reflect the potential competition.
This is the catch-all category for late fees, net box sales, truck-rental commissions, and lock and insurance sales. If this number is more than 10 percent of the rental income, it is possible a different valuation may be required to properly evaluate this source. As the amount grows larger, it may represent "another business," and not miscellaneous income. Such business income is usually valued much lower than real estate income, and is often not counted by appraisers for loan purposes.
It is considered a rule of thumb that operating expenses run between 30 percent and 40 percent, with many in the 35 percent range. If your project falls out of this range, further analysis may be required. The following items describe the expense categories in more detail:
Real Estate Taxes. This looks simple, but it really isn't, because real estate taxes can change dramatically if the property is reassessed. Properties are usually reassessed at time of sale, often resulting in a higher tax based on the new price. A buyer will often evaluate the property based on the "new potential" taxes rather than the actual, which will cause the price he is willing to pay to be lower. Additionally, some taxing jurisdictions may reassess every three to five years, so you must figure out where you are in this cycle and adjust accordingly. If, at the end of this exercise, you find the computed value range greatly exceeds the value shown on the tax bill, it is a good indication you may have a problem with increased real estate taxes and, thus, a lower value.
Salaries and Benefits. This is where salaries, fringe benefits and employee bonuses are accumulated. If someone works on site unpaid--including yourself--calculate what it would cost to replace this person and add it to the category. These numbers will vary significantly based on facility size and locale. Skip this last step only if you are willing to stay working on the project for free, forever. Don't include excessive benefits, such as generous pension plans, auto leases, silver-plated medical plans or key-man life-insurance policies.
Insurance. This category should include all costs for property and liability insurance. If you believe you will be receiving a significant cost increase, use the larger number.
Utilities. This category is relatively straightforward. Include costs for electricity, gas, fuel, oil and water.
Maintenance and Repairs. This category should include painting, door repairs, asphalt repairs, structural and roof repairs, and other things routinely repaired during the course of the year. Snow removal and landscaping maintenance may also be put in this category, as well as other routine maintenance contracts such as HVAC or pest control. If you have made major capital replacements or additions, delete them. This may include things such as a new gate, software, roof replacement, major landscaping or fence replacements. The general rule is if your accountant requires you to capitalize the expenditure, do not include it here. If your property has excessive deferred maintenance, an adjustment will be deducted in the final valuation to compensate for these items.
Capital Reserves. To account for these capital items, an artificial reserve is usually included in the computation of 10 to 15 cents per square foot. This is not an actual expense that will show up on your statement, but rather a number you should compute and deduct here.
Management Fees. If you pay a management fee to a third party, include it in this category. If you don't, you should add a management fee to your expenses of between 3 percent and 6 percent of gross revenue depending on the size and location of your facilities. This additional expense is necessary because value is based on investment returns and must include all management costs for the investment.
Marketing and Advertising. This category includes Yellow Pages, radio, TV, newspaper and Internet advertising.
Office Expenses. This category includes telephone services, supplies, software repairs and fees, bank fees, and other miscellaneous office expenses. Operating and business licenses can also be entered in this category.
Miscellaneous. This is the category where other necessary but minor expenses are included. Don't include your convention, travel or other personal charges, such as lunches or massages.
Depreciation. Do not include depreciation. Depreciation is not included by definition. For a detailed explanation as to why, read the article at www.selfstorage.com/argus/articles/valuation_0203.pdf.
Interest. Do not include interest, as it is not a charge against operating income. However, if you have a loan and it has a prepayment penalty, lock in or yield-maintenance requirement, see your appraiser or broker, as these loans may affect value and marketability significantly. The devil is in the details with regard to loans with these provisions, and they must be reviewed very carefully to determine the nature and magnitude of the impact.
Land and Building Lease Payments. Land and building leases can negatively impact value. Because the terms vary as to rent, length of term and other important clauses, any generalization is inappropriate, and you should confer with a highly qualified appraiser or broker to determine the significance of the lease. Unusual easements on the land can also have a major impact on value, as can nonconforming zoning, flood planes or environmental concerns. Each of these issues deserve very careful analysis and may impact the values, negating the ranges contemplated in these calculations.
Net Operating Income
After subtracting operating expenses from revenues, you have what is known as net operating income (NOI). This is not cash flow, as it is sometimes erroneously called. Cash flow is NOI minus debt service (both principle and interest).
Real estate is often valued by a process of capitalizing the NOI at what is called a capitalization rate. The capitalization rate, or cap rate, is the approximate rate an investor would receive without a loan on the property. (For a fuller discussion of cap rates, you can read the article at www.selfstorage.com/argus/articles/caprates.htm). Since this is a complicated subject, I will stick to the math. Suffice it to say great properties in great locations have lower cap rates and higher prices, while less-desirable properties have higher cap rates and lower prices. Most properties sell between a 9.25 and an 11.0 cap rate.
For our example, we will use a 9.5 cap rate and an 11.0 cap rate, which will define the range for about 80 percent to 90 percent of all facilities. To find the estimated value, divide the NOI by .095 and .11. The resulting numbers will give you an approximate range of value. If your NOI is $251,000, the range of value may be between $2,642,000 and $2,400,000.
Remember, this only applies if all of your assumptions are correct and there are none of the special considerations discussed in this article. You should never price a property based on this analysis, but confer with an appraiser or experienced broker. You may be too low and miss a profit, or too high and not make a sale. Use these value ranges as a general planning tool only.
The ultimate value may be influenced by many other factors beyond the scope of this exercise, such as extra land, excessive overbuilding, deferred maintenance or a changing location preference such as a new freeway, to name a few. Knowing the math mechanics of value will be useful when talking with a valuation expert; but in the end, as your science teacher said, this may not be something to try alone at home.
Michael L. McCune has been actively involved in commercial 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.
Rental Income $____________
Miscellaneous Income $____________
Total Revenues $____________
Real Estate Taxes $____________
Salaries and Benefits $____________
Maintenance and Repairs $____________
Capital Reserves $____________
Management Fees $____________
Marketing and Advertising $____________
Office Expenses $____________
Total Expenses $____________
Net Operating Income (NOI) $____________
9.5 Cap Rate: Divide NOI by .095 $____________
11.0 Cap Rate: Divide NOI by .11 $____________