In the business of buying and selling self-storage properties, the discussion for buyers and sellers always ends with capitalization (cap) rates. Unfortunately, most people don’t fully understand all the ramifications of this simple-sounding number. It’s also clear we have many new investors in the marketplace who have never bought an income-producing property and are just learning the basic math. Hopefully, this summary will help clarify this mysterious yet fundamental concept.
What Are Cap Rates and Why Use Them?
Real estate valuation is a very complex business, with many variables that affect the price. Over the years, real estate professionals found they needed a way to compare property values (price) in a market using a shorthand method, thus cap rates came into general use.
Essentially, cap rates tell an investor what he should expect to earn as a percentage if he purchases a property using all cash. For example, if an investor thinks a property is worth a 7 percent cap rate, then he expects to receive an unleveraged 7 percent cash-on-cash return.
When the net operating income (NOI) is divided by the cap rate—voila!—you arrive at a property value. This method is essentially a way to develop a price based on an income stream. The net result is the lower the cap rate, the higher the value; the higher the cap rate, the lower the value. This is only one of the three methods used by appraisers to value a property, but it’s the one most focused on by investors. It’s primarily used because it does a very good job correlating property values and helps facilitate comparison between markets.
The Underlying Assumptions in Calculating NOI
As with any good rule of thumb, there are certain assumptions that are implicit in the calculation of the NOI. For cap rates to be useful and comparable, the NOI must be calculated on a consistent basis on all properties. For example, the operating expenses must be similar in nature and somewhat standardized to compare “apples to apples.” The first assumption when calculating the NOI is that all revenue must result from reoccurring operations of the property (rental revenue) and not from an asset sale or insurance recovery.
Second, depreciation and debt service should not be deducted from revenue to arrive at the NOI. Depreciation and financing costs do not reflect value but merely tax issues and capital structure. These revenue assumptions are clearly defined and are almost universally applied.
However, assumptions related to expenses are less uniformly applied and result in significant misunderstanding, particularly among sellers. The assumptions should include that the property is properly insured and advertised in a professional way. Property taxes should be adjusted to what the new valuations will be at the time of sale.