Forecasting economic trends, particularly in real estate, is risky business. However, failing to pay attention to trends such as interest rates, cap rates and overall investor confidence is even riskier. Self-storage owners make or lose money because they’re in the real estate business, not the self-storage business, even though their facilities may be an extremely reliable income stream.
The value of your self-storage property is affected far more by economic trends that impact the real estate market than by operational factors. Today investors not only have capitalization-rate risk but interest-rate risk. The first thing to remember is income creates the basis for value.
In real estate, the relationship of income to value is called a capitalization (cap) rate, which is the rate of return an investor will expect on the invested equity without taking into consideration debt on the investment. If you think about the return on an investment, a low return or cap rate usually implies a higher value for the same income. Conversely, a high return or cap rate usually means a lower value for the same income. This ratio, or cap rate, is set by buyers and sellers in the market.
Property-specific and market conditions also have a dramatic effect on cap rate. Together, they determine what buyers and sellers—who often do not agree on associated risk—feel is an appropriate cap rate for an investment. Therefore, it’s important for self-storage owners and real estate investors to understand the risks and factors affecting value in the market. If you do the math, you’ll see that capitalizing market conditions will have a greater impact on an investment’s internal rate of return (IRR) than simply renting more units and improving facility operation.
The ‘True’ Cap Rate
First, understand a cap rate is a mysterious number and changes from one property to the next—there is no standard. When you hear someone say they bought a property on a 10 cap or sold on a 7 cap, remember many things affected those rates.
The relationship of income to value changes from asset to asset. Property-specific actors include:
- Is the property on a land lease?
- Is the market overbuilt?
- How difficult is it to develop a new project in the market?
- How many competitors are in a five-mile radius?
- Who are the competitors?
- Is the state considering a sales tax on self-storage rentals?
- What’s the quality of construction on the project?
Market conditions may have an even bigger effect on the cap rate and include such things as investor confidence, inflationary risk, interest-rate risk and the availability of financing. There simply isn’t one number that can be used to value every project. Every property has its own set of risks.
Interest Rates: What’s Next?
The continuing low-interest-rate environment has had a dramatic impact on self-storage investments over the last six to nine months. The most obvious and positive effect is owners are able to sell their properties for close to historically high prices or refinance and keep a larger share of their hard-earned income by paying less to their lenders in the form of interest.