A cap rate is a basic valuation tool that represents the projected one-year return of a property as if it was purchased with all cash (no financing). The advantage of using a cap rate is it accounts for vacancy and credit losses, as well as all operating expenses. However, there are limitations. For example, a cap rate doesn’t take into consideration financing or any incometax implications. Nonetheless, it’s an effective tool when accurate information and the correct methodology are used.
The key to any valuation using a cap rate is determining an accurate net operating income (NOI). NOI is gross income minus operating expenses (excluding interest and depreciation). For example, a property with gross income of $300,000 and expenses of $100,000 has an NOI of $200,000.
A cap rate is determined by dividing a property’s NOI by its sales price. For example, a property with an NOI of $200,000 and a sales price of $2.2 million has a 9.1 percent cap rate.
To correctly calculate a cap rate and get a fair comparison of properties, you need to obtain accurate income and expense information for each property and confirm the computation for each was performed in the same manner. When determining the NOI of any property, the income is usually easier to verify than expenses. There are many sources to help determine actual revenue collected, such as rent rolls, occupancy reports, management summary reports, revenue-history reports, deposit reports, etc.
The area of operating expenses is where more discrepancies occur, as these items must sometimes be extracted from categories not specific to the operation of the facility. There may also be missing expenses that should be included, for example, payroll for an on-site manager (unless the plan is to operate the site remotely), third-party management fees, replacement reserves, insurance, advertising, and repairs and maintenance. Please note that operating expenses do not include any debt service or depreciation, so these items should be excluded.
Once the correct NOI has been established, a buyer can use a cap rate to obtain an initial assessment of any property. Conversely, a seller can use it to establish an appropriate asking price. Regardless what side of the transaction you are on, absence of a correct NOI renders any valuation using a cap rate meaningless, so thorough due diligence is a must.
It’s easy to see that a lower cap rate produces a higher sales price and is better for a seller, while a higher cap rate produces a lower sales price and is better for a buyer. Setting aside the goals of both parties, the market will ultimately reflect equilibrium—what buyers are willing to pay and sellers are willing to accept. This will be the point at which similar properties in the same market will sell.
When there are enough sales of like properties in a single market and their NOIs were calculated in a similar manner, a “market cap rate” is established. At this point, the market has essentially spoken and, with few exceptions, the vast majority of properties will sell very close to this cap rate. Buyers who make below-market offers and sellers seeking above-market prices don’t consummate many deals.
In practice, the market cap rate is considered more of a range than an exact number, given that no two properties are exactly alike. There are many characteristics that differentiate similar facilities, such as age, location, occupancy history, deferred maintenance, land for future expansion, etc. The range typically covers half a percentage point, for example, 9 percent to 9.5 percent. The upward or downward movement of this range primarily depends on external market factors such as interest rates, the availability of capital, the number of properties for sale, and the number of prospective buyers at any point in time.
The widely held belief that the spread between interest and cap rates remains narrow regardless of other factors is based on the realization that real estate values are directly influenced by the cost of financing. Lower debt service means investors can obtain their desired internal rate of return, or yield, over a projected holding period at a higher purchase price. As a result, real estate values rise (and cap rates decline) as buyers compete for properties.
For example, during the recent period of low interest rates and more-than-adequate flow of capital, cap rates appeared to reach record lows. On the other hand, when interest rates rise, the opposite occurs. Higher debt service means prices tend to decline (and cap rates rise) for buyers to obtain their desired yield.
Again, a cap rate isn’t the only available tool, but it can play an important role in self-storage valuation. For buyers, it is often the first method used to filter potential acquisitions, providing a quick and efficient way to determine whether a property warrants further examination. For sellers, it’s a quick and fairly accurate method to determine what a facility will sell for in a market. The important thing to remember is a cap rate, like any other valuation method, is only as accurate as the data used in its calculation.
Rob Schick is senior vice president of Revel & Underwood Inc., which was established in 1973 and specializes in the disposition and acquisition of self-storage facilities. He has more than 15 years of experience in investment real estate sales and represents self-storage buyers and sellers throughout the United States. For more information, call 800.875.5439, ext. 166; e-mail: firstname.lastname@example.org.