Buyers of investment properties base their offering price on market capitalization rates or “cap rates.” A cap rate calculates the value of real estate based on the expected or desired annual rate of return, expressed as a percentage of expected income over purchase price. Market cap rates can be determined from comparable sales of recently sold properties. If a property produces $400,000 in net operating income (NOI) and sells for $5 million, it generates in an 8 percent return on investment ($400,000 divided by .08 = $5,000,000).
Consider two different facilities with the same physical characteristics and annual operating income of $400,000. One is built in a good location, the other is not. Let’s say facilities in the “good” market have been selling at a cap rate of 8 percent, as in our example above, while facilities in the “bad” market have sold at a cap rate of 10 percent. The sale price for the former would be $5 million; the sale price for the latter would be $4 million.
The disparity in value between the two facilities is attributable to differences in the quality of the site. That pricing differential would be even more extreme if the inferior location did not perform as well and produced a lesser NOI. What we’re seeing in capitalized self-storage value today is the spread between institutional-quality and inferior locations is widening, bringing even greater rewards to well-located facilities.
After finding a market with suitable sites based on competition, traffic patterns, population growth and barriers to entry, the developer must evaluate site-specific attributes of potential locations. Critical site-selection elements relate to zoning and land-use controls (imposed by local authorities), topography and site configuration.
Development expenditures go far beyond the cost of the dirt when all these elements are factored. Thus, a less expensive site may not be “cheaper” in the long run. For example, if a property needs additional fill or extension of utilities, the costs increase proportionately. The final bill for “needy” properties can be significantly higher then a site that already has some or all the critical elements necessary for development.