Yes, you can have your cake and eat it too! Here’s how to cash out but keep the revenue flowing and equity growing in your self-storage business.
If you stuff thousands of dollars under your mattress, it can’t earn you a penny. It’s similar to trapped equity. Many self-storage owners have no idea what their businesses are worth and, as a result, may not realize how much trapped equity they have. Many think their equity investment is the original cash invested in the business. Trapped equity, on the other hand, is the current value of your business minus the debt. Your first step to discovering how much you have is to determine your business’ value.
This can be done in a number of ways, but to illustrate, we’re going to use the income capitalization approach. For this example, let’s assume the property has a stabilized occupancy. Take the net operating income (NOI) for the last 12 months and divide it by a capitalization rate. NOI equals gross revenues, less normal operating expenses, excluding interest expense and depreciation. Also excluded from NOI are capital expenditures, owner’s expenses and other non-recurring expenses.
UNDERSTANDING CAP RATES
If you’re willing to pay $1 million for a $100,000 income stream per year, then you’re earning 10 percent per year, which translates to a 10 cap rate.
If you pay $1.25 million for the same $100,000 income stream per year, your earnings are 8 percent per year, or an 8 cap rate.
The next step is to find the cap rate for your business. Numerous factors affect cap rates: geographic location, occupancy history, facility condition, competitive environment, etc. For our equation, we’re going to use an 8 cap rate. Let’s see how trapped equity may have grown over the years and its impact on investment return.
- $10,000 increase in NOI per year
- Cap rate decrease from 10 to 8 over a five-year period
- Debt payoff of $50,000 per year
Our example starts with an NOI of $125,000 and grows to $175,000 per year. At the same time, cap rate has gone from a 10 to 8 over the same time period. You can see from the chart below the impact these two variables have on value—from $1,250,000 to $2,187,500 in just five years.
Now, subtract debt from value; the resulting figure is your trapped equity. While we may have started off with just $250,000 of equity in a self-storage business, it’s grown to almost $1.5 million!
It’s obvious the impact the equity increase has on your return. The return calculation that is most often used in the self-storage industry is called cash-on-cash return. The formula:
Net Cash Flow (NOI-Debt Service)
Cash Invested (Equity)
When you apply the formula to our example, the cash-on-cash return drops from 30 percent to a single-digit return, as can be seen below:
The result is a substantial amount of trapped equity earning the same return as if it were under your mattress—a big-fat zero.
Slicing Into Equity
Now that we’ve discovered trapped equity, you have two ways to get your hands on it: Sell your business, pay off your existing loan and pay the taxes on your increase in value; or refinance your loan and pull out the majority of trapped equity.
If you consider selling your business, you’ll be hit with a 15 percent in capital gains tax. But that’s not all: Other costs and additional taxes need to be calculated into the sale, and they’ll significantly reduce the amount of trapped equity you’ll be able to pull out. Following are the assumptions for the sale of a typical self-storage business:
- $2,200,000 selling price (value)
- Adjusted cost basis of $900,000
- Taxable gain of $1,300,000
- Debt of $750,000
- Accumulated depreciation of $250,000
- Capital gains tax of 15 percent
- State tax of 7 percent
- Recapture Tax of 25 percent
- Real estate commissions/legal—6.2 percent of selling price
The capital gains tax of 15 percent in our example equates as follows:
$2,200,000 - $900,000 = $1,300,000 gain
$1,300,000 gain X 15% = $195,000
In addition, you’ll most likely have a state income tax liability and recapture tax on the depreciation you’ve taken as a tax expense over the years of ownership. These taxes on the gain take a big bite out of your equity. In our example, the recapture tax alone is $62,500 ($250,000 X 25 percent). Check with your accountant for the applicable state tax rate on the gain. In our example, we’ll use 7 percent.
Below is a summary of the net cash out:
What about refinancing to pull out your trapped equity? The math for a refinance is much simpler because of fewer deductions. Following are the assumptions using the same self-storage business in the above example:
- $2,200,000 value
- Loan amount of $1,760,000, or 80 percent of value
- Debt of $750,000
- No tax liability at entity level for a refinance (check with your tax accountant for clarification)
- Loan origination fee/appraisal/legal = 2 percent of loan amount
- 10-year, fixed-rate loan at 6 percent with a 30-year amortization
When you run the numbers on the refinance scenario, you come out slightly ahead:
Because you’re still an owner if you refinance, you’d still have equity in the business. In addition to the 47 percent advantage of refinancing versus selling the self-storage, you’d generate almost $50,000 per year in cash flow after debt service on the new loan.
The other advantage of refinancing is you’ll continue to enjoy growth in value. Plus, with the refinance cash out, you can grow your net worth by buying or building additional self-storage facilities. A $1 cash fund could translate, through leverage, into a building/acquisition fund of in the $5 million range.
The recipe for success here is a simple one: You can have your cake and eat it too ... by slicing into your equity and letting it work for your business.
Bill Walton is an executive vice president with S&W Capital and Realty LLC, specializing in refinancing self-storage loans nationwide. He also assists self-storage owners in determining the amount of their trapped equity. For more information, call 888.525.908; e-mail firstname.lastname@example.org; visit www.sandwgroup.com.