Cap Rates—A Mystery Unveiled

Michael L. McCune Comments
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If you are buying, selling or refinancing a self-storage property, you can’t have a three-minute conversation without the term “cap rate” coming up. Everyone acts as if they know what this is—a few really do know, many more think they know, and some refuse to admit they don’t know. This article should provide a little insight and clarification on the topic.

What is a cap rate? The term is an abbreviation for “capitalization rate.” It is simply the return an un-financed property yields at a specific value. For example, if a property produces $200,000 in income and you want a 9 percent return on your investment, you would buy it for $2,222,222 ($200,000 divided by .09). The cap rate represents the relationship of the property’s value (price) to its income. Since the numbers are directly related, real estate folks like to talk about cap rates instead of value, since it allows them to compare values of very different properties or property types.

In other words, if someone says one property with a $100,000 income and another with a $1 million income are a “9 cap,” he is saying the income from both properties would produce a 9 percent return on their respective prices. The properties are valued the same based on relative income. Alternatively, if one property was valued at an 11 cap rate and other at an 8 cap rate, the fi rst property would be worth much less than the second because the price would have to be lower to generate the higher return.

So, if you know the cap rate and the income, you know a property’s value, right? Well, now things get tricky. Let’s refine our understanding.

What Is Income?

The “stabilized income” used in the calculation of value is not what you put in the bank or report to the government. There are adjustments to be made. First, you do not reduce income by depreciation or debt service (interest and amortization). Second, you subtract from expenses any personal items and add a fair rate for your time spent on the property. (If your miscellaneous revenue exceeds 5 percent of your gross, get some advice, because your situation may be treated differently.) Your adjusted income is referred to as your net operating income (NOI). Cash flow is what you put in the bank after you pay the loan but before you pay federal and state taxes.

What does the word “stabilized” mean in relation to income? When considering value, i.e., a sale purchase or refinance, the income that produces it must be stable. A couple of examples will show you what I mean. Let’s say the Olympics came to town and the contractors rented all of your units at twice your normal rate. That year’s income would not be normal, or stabilized. Alternatively, income from a year in which fire destroyed half of your units, putting them out of commission for six months, would also not be stabilized. Neither situation represents standard income for the property.

A more typical situation in many markets would be a facility that is 93 percent occupied while others in the market are 78 percent occupied on average. What is stabilized income in this case? It may depend on other factors such as access, location, pricing or management. What is clear, however, is stabilization introduces a large dose of subjectivity to the otherwise simple process of determining value.

There are some shortcuts people use in developing values for selfstorage and other real estate. The most common is the “trailing 12 months” cap rate. This tactic simply substitutes the average of the previous 12 months’ NOI for a stabilized one. The assumption is that nothing significant in the facility or market will change. Sometimes this is true, but not nearly as often as the method is used. This shortcut can be risky and can cut both ways. While it may be handy for a quick look, most serious professionals prefer to evaluate all of the information.

There are other items that affect value but are kept separate from the capitalization formula, even though they may relate to future income. These “adjustments” could include extra land, ground lease, deferred maintenance, and associated businesses. They require a more detailed explanation than I can provide here, but they are important to consider.

What Is the ‘Right’ Cap Rate?

You have probably heard people talking about cap rates going up or down, or saying things like, “I sold on an 8 cap rate” or “Cap rates are lower in California.” What does all this mean? Remember that cap rates are just another way of talking about prices in relation to income. But because of the way the math works, lower cap rates mean higher values. So when someone says cap rates are down, they mean prices are higher.

As we have learned, when a buyer purchases a property at a certain price, he is also estimating the return he stands to receive. That return is the cap rate. Let’s revisit our numbers from earlier: A 9 percent return on a $2,222,222 property is $200,000 per year. The cap rate is a 9. If the buyer only needs an 8 percent return, he could pay $2,500,000 for the property (200,000 divided by .08). In that case, the cap rate would be an 8.

When we compare sales in a market, we find that similar properties tend to sell on like cap rates. When someone says a market is a “9 cap market,” he means sellers and buyers are tending to agree on prices that yield the buyer 9 percent on the price. Some properties will be less desirable and may sell at a 10.5 cap rate (lower price), while more appealing locations might sell at an 8.5 cap rate (higher price).

The reason for all this agreement between buyers and sellers is they are always looking at alternative investments and evaluating self-storage against them. If corporate bonds are yielding 10 percent, people will be more likely to invest in bonds than self-storage. However, if the bonds are returning only 6 percent, investors may decide the extra risk of self-storage makes a facility at a 9 percent return look good. Thus, cap rates tend to rise and fall with the returns on competitive investments and interest rates. The general (average) cap rate is then adapted to the specific property based on a number of factors.

In the accompanying chart, I have attempted to summarize some of the characteristics of self-storage facilities in different cap-rate ranges. This will give you an idea of some of the property-specific attributes that create and diminish value. The general investment market will rise and fall, but the relationships on the chart tend to remain important as the general levels change. Note the cap rates are not specific, and the descriptions are representations only.

CAP-RATE ADJUSTMENTS
Cap-Rate Range
Item “8-ish” “9-ish” “10-ish”
Occupancy (Last Two Years) 95% - 100% 90% - 95% < 90%
Rates (Last Two Years) Continuous Rise Steady Falling
Facility Size >45,000 30,000 to 45,000 <30,000
Competitors (3-Mile Radius) None One More Than One
Competition’s Occupancy 95% - 100% 90% - 95% < 90%
Surrounding Area Growing Metro Large City Rural
Density (5-Mile Radius) >200,000 100,000 to 200,000 <100,000
Traffic Count >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
Technology Computers and Self-Storage Accounting Software Computers None
Construction Concrete or Brick Brick and Metal Metal
Maintenance Pristine Little Deferred Maintenance Modest Deferred Maintenance
Security Full Gate and Card Access Full Gate Access Other
Street Access Very Direct Clear, but not Direct Difficult
Visibility Can See Sign and Facility Can See Sign and Entrance Can See Sign Only
Drives Concrete Paved Gravel

Other Kinds of Cap Rates

Cap rates were originally intended to be a useful tool to compare properties’ rates of return to their values when the rates are carefully prepared. However, in the real world, something different is happening in the market. Many people are using cap rates for bragging rights. Sellers, buyers and brokers are making up low or high cap rates so they can satisfy their own needs, egoistic or otherwise. They usually justify this by playing with income projections, if they bother to justify it at all.

So, now that you know more about cap rates, be sure you are dealing with real numbers prepared by someone with the professional accuracy required to really understand value. Any other cap rate (too high or too low) is only meant to serve the purveyor’s interest and not yours.

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 1994, he created the Argus Self Storage Real Estate Network, now the nation’s largest network of independent commercial real estate brokers dedicated to buying and selling self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.

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