Real Estate Roundup 7575

While the word arbitrage is usually thought of as a high-finance concept, viable opportunities might be available in the self-storage world. Arbitrage means investors can take advantage of pricing or other discrepancies in the marketplace. For example, if a stock sells on the London Exchange for $50 and on the New York Exchange for $55, its clear you should buy in London and sell at the same time in New York. Do it once, and you are entitled to call yourself an arbitrageur (even though it sounds French, dont let it go to your head). Regardless, lets talk about how we can make arbitrage work in our markets.

First we must discover a price difference or other discrepancy in the market that might be useful. As we know, capitalization rates (cap rates) are, in the simplest form, the rate of return demanded by a buyer to purchase a property. In other words, if a buyer is willing to pay a cap rate of 6 percent for a property, then each dollar of net operating income (NOI) is worth $16.67.

Likewise, if the cap rate is 8.75 percent, each dollar of NOI would be valued at $11.29. Thus, cap rates can, in large measure, be viewed as a surrogate for price because what a buyer is really purchasing is the income. Just remember, a higher cap rate means lower prices. (For more information about cap rates, search for McCune in the article archive at www.insideselfstorage.com.) I recently asked some self-storage brokers to give me a range of cap rates in their various territories to see if we can find an exploitable price discrepancy. Chart 1 is a tabulation of that inquiry. As you can see, the market provides a considerable variation in cap rates and, thus, price discrepancies, just based on geography.

On the West Coast, cap rates are lower, which means prices are higher per dollar of NOI than they are in the South-Central region, Southeast and Southwest. While the difference could be due to many reasons, most will likely relate to the number of buyers and sellers in the area rather than intrinsic valuation issues with the property.

A self-storage market is approximately a 5-mile radius around each property, but geography probably isnt as important as many other things when evaluating facility income. In other words, an excellent project in a stabilized market in Madison, Wis., or Birmingham, Ala., is probably equal to a comparable project in Thousand Oaks, Calif., or Montclair, N.J., in terms of generating a stable and growing income.

Chart 2 examines the impact of arbitrage on a self-storage investment. Our example shows two properties with identical NOIs of $200,000. The property with the low cap rate has a value of $2,963,000, while the property with the higher cap rate has a value of $2,422,000, a price differential of $541,000.

The net result of the arbitrage is such that if you sold the low-cap project and bought the high-cap one, you wouldat a minimumdouble your cash flow. The second column shows the results if an owner sold the project in the low-cap market and reinvested all sale proceeds in a project with exactly the same NOI in a market with a high cap rate.

The last column shows the results of selling the low-cap project, pocketing the $541,000 profit and financing a project with the same $200,000 NOI at 75 percent of value. As you can see, the results of such a transaction can be quite dramatic, as cash flow can increase to more than 3.5 times the amount of the low-cap project.

Clearly, theres value in understanding cap-rate arbitrage in self-storage and any real estate. The rewards make the game worth playing; the trick is making sure the difference really is in price and not quality of the project. How long will these opportunities remain? Your guess is good as mine, but in the arbitrage game, its all about carpe diem!

Michael L. McCune is president of the Argus Self Storage Sales Network, a self-storage real estate brokerage and development company based in Denver. Argus also operates www.selfstorage.com, a marketing medium for owners in the self-storage industry. For more information, call 800.55.STORE.