In recent conversations with self-storage owners, I’ve noticed the majority are enjoying stabilized revenue and, in some cases, increased revenue over the last six to 12 months. Most don’t realize that they’ve made or lost money, not because they’re in the self-storage business, but because they’re in the real estate business.
While an increase in revenue is creating more cash flow for owners, the real opportunity today lies in the arbitrage between capitalization (cap) rates and interest rates on which a real estate investor can capitalize. Arbitrage is usually thought of as a high finance concept, but there are some viable opportunities that might be available in the world of self-storage. It means an investor can take advantage of some pricing or other discrepancies in the marketplace.
In its simplest form, a cap rate is the return a buyer demands on an investment without taking leverage into consideration. For example, if a buyer is willing to pay an 8 percent cap rate for a property, every dollar of net operating income (NOI) would be worth $12.50 in value ($1 / .08 = $12.50). If the cap rate is 9 percent, every dollar of NOI would be worth $11.11 ($1 / .09 = $11.11).
As you can see, lower cap rates equate to higher values and higher cap rates equal lower values. Thus, the cap rate has more to do with the property value than the actual day-to-day operation. In reality, the buyer is purchasing the income stream rather than the property. Although I’ve used a generic illustration here, it’s important to note cap rates are property- and market-specific, and there’s no standardized cap rate that fits every property.
The Impact of Arbitrage
I took a closer look at some recent cap rates on self-storage closings and how the properties are being financed. Cap rates are ranging from 7.75 percent to 9.25 percent for stabilized properties, with the average falling somewhere around 8.25 percent.
I also looked at the financing terms most buyers are able to achieve today and observed the following: For one to 10 years, the interest rates are between 4.5 percent and 7 percent, and amortization schedules are between 20 and 30 years. This puts the spread between interest rates and cap rates somewhere between 100 to 475 basis points, with the majority being greater than 250 basis points.
The accompanying chart shows the impact arbitrage can have on a self-storage investment when the cap rate is significantly higher than the interest rate. The net result of the arbitrage between cap and interest rates is the greater the spread between them, the greater the return an investor will receive on his equity.
Clearly there’s value in understanding the benefit of some of the lowest interest rates in the last 40 years. The rewards make the game worth playing, and the trick is to make sure the spread between the cap and interest rates provides you with a return you can live with. The question to ask is how long will these opportunities last? Your guess is as good as mine, but in the game of arbitrage, it’s all about carpe diem!
Ben Vestal is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE; e-mail firstname.lastname@example.org .