As a self-storage real estate professional, I find the fundamental question that seems to come up at the end of almost every business conversation is also the most difficult to answer: What are capitalization (cap) rates today? Unfortunately, most people don’t understand the impact this one simple number has on the overall value of a self-storage property and, more important, what goes into arriving at an appropriate cap rate for a property.
I 'll go one step further and suggest cap rates may not be the best tool in valuing self-storage properties. In today’s yield-hungry investment market, I find investors are more concerned with the cash-on-cash returns they’ll receive when buying a property than with the actual cap rate.
If you’re an astute real estate investor, you understand that a cap rate is one component to arriving at the cash-on-cash return. Today, a more appropriate question a buyer or seller may consider asking is what are the terms of the debt one can obtain on this property? The current aggressive debt market has caused cap rates for self-storage properties to compress to historically low levels. However, I’ve recently found myself asking the question, is the property making the investor money, or is the debt making the investor money?
Taking Advantage of Pricing
While the word “arbitrage” is usually thought of as a high finance concept, there may be some viable opportunities that are present in today’s self-storage investment market, even with historically low cap rates. The term “arbitrage” means an investor has the opportunity to take advantage of some pricing or other discrepancies in the marketplace.
The accompanying chart indicates why this may be possible in today’s self-storage market. The green line indicates the average cap rates for self-storage properties over the last 10 years. A cap rate, in basic terms, is the unleveraged return an investor can expect without putting debt on the property. The blue line indicates the interest rate for 10-Year Treasury over the last 10 years. The 10-Year Treasury is the benchmark for most commercial real estate loans, and financial institutions will use this rate plus an additional spread to arrive at an all-in interest rate that will be offered to the borrower. The red line, then, indicates the spread each year between the cap rate and 10-Year Treasury and will give you a feel for the “arbitrage” buyers have been able to obtain over the last 10 years.
As you can see, the spreads shrank to around 254 basis points at the top of the real estate boom in 2006 and 2007. The spreads expanded to 531 basis points at the height financial crisis in 2009 (who can forget that?). In 2012, the spread hovered around 486 basis points, which has enabled buyers to pay very aggressive prices while generating compelling cash-on-cash returns.