Whose Cap Rate Is It?

Nicholas Malagisi Comments
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Buyers and sellers of investment real estate are always looking for ways to measure their most recent acquisition or sale. Some buyers will use an industry rent multiplier to see if their property is in the range of 5.5 to 7.5 times gross collected rents. Some will compute the purchase price per square foot paid compared to similar properties. But most investors will look at the capitalization rate as a measure of how good a deal they just bought. Self-storage is no exception to the use of this measurement of value.

So what is a cap rate, and how do we use it to compute value of a self-storage facility? The capitalization analysis is used to determine the present value of anticipated future income. Cap rates are mostly market driven and vary based on the type of investment real estate (apartments, shopping centers, office buildings), as well as many other factors such as location, age, type of construction and management of the property.

Appraisal methodology simply states that the value (V) of the property is calculated by dividing the net operating income (I) by the cap rate (R) (net operating income being income before debt service, income taxes and depreciation). Conversely, the cap rate is determined by dividing the purchase price (V) by the net operating income. You end up with the following formula: V = I/R.

It so happens that in today’s low interest-rate environment, a quality self-storage facility can sell for a 9 cap rate. The cap rate could be lower if the property is being acquired by a motivated buyer looking to do a 1031 tax-deferred exchange or someone looking to increase or protect his market share; or if a property is a part of a portfolio sale. The cap rate may also be higher if there is deferred maintenance or the property is “functionally obsolete” by today’s standards.

Remember, there is an inverse relationship between the cap rate and purchase price. The higher the cap rate, the lower the value/price. The lower the cap rate, the higher the value. The buyer usually places a higher cap rate on a property he perceives to carry greater risk. The “$64,000 question” is not necessarily which cap rate is used to determine the value/purchase price of the property, but what income and expenses did the buyer use to derive his net operating income? Did he use last calendar year’s income, the trailing 12 months of income or a projection of current annualized income?

There are several other items that could affect that income figure. For example, in reviewing the seller’s expenses, did the buyer change the size of the Yellow Pages ad? Did he add more payroll/benefits because he is going to open the office on Sundays? Is he going to enlist the help of a national call-center service? Does he plan to implement a free truck-rental program to be more competitive and aggressive in soliciting new customers?

Changes in any of these expense categories will alter the net operating income used in the buyer’s analysis in comparison to the actual income and expenses of the subject property. All of these questions and others go into the buyer’s calculations of what income and expenses to use when applying the formula V=I/R. This will determine the cap rate and, ultimately, what price the buyer is willing to pay for the facility.

Nicholas Malagisi is president of Storage Realty Advisors, a commercial real estate brokerage firm specializing in the sale of self-storage facilities, primarily in the Northeast. Malagisi has participated in the sale of more than $93 million worth of selfstorage properties since 1993. He also prepares feasibility studies for new projects. For more information, call 716.633.9601; e-mail nmalagisi@storagerealty.com; visit www.storagerealty.com

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