By The Mele Group of Marcus & Millichap

Self-storage facilities provide their owners with a lucrative source of income and a nice lifestyle. However, buying a business isn’t a simple process. It requires a hefty initial investment, which makes the ability to accurately value a property essential—both at the time of purchase as well as when it comes time to sell.

In general, determining the value of a storage facility is the same as for any other real estate. There are several methods used for establishing an accurate assessment. Each bases value calculations on “highest and best use,” an assumption that considers the most profitable, competitive use for the property.

When it comes to self-storage, valuations will vary depending on whether a facility is in lease-up or stabilized. The overall condition of the property is also a factor. For the purposes of this article, we’ll focus on the income-capitalization method of valuation.

Cap Rates

Real estate valuation is complex, especially since there are many elements that affect pricing. In the self-storage industry, a conversation about capitalization (cap) rates almost always arises. Cap rates are determined by the amount of risk-adjusted return an investor is willing to accept for his investment. Property location, age and size are all taken into consideration.

With treasuries at historically low rates—the 10-year note is yielding around 1.57 percent at the time of this writing—investors are clamoring to find yield-producing assets. Institutional investors have recognized the virtues of the self-storage asset class, which has driven down cap rates by 200-plus basis points in recent years. However, cap-rate compression in the self-storage sector has been decelerating, with the average cap rate on transactions currently below 6 percent. Although compression has subdued, properties continue to reward owners with stable income growth and minimal volatility during economic downturns relative to other real estate.

The Importance of NOI

Income capitalization specifically targets a business’ cash flow. With the cap rate, calculations convert annualized income into a return-on-investment (ROI) formula to establish a property’s value. The formula for calculating ROI divides net operating income (NOI)—the amount left over after expenses are subtracted from annual income—by the sale price.

Because self-storage value is based on cash flow, it’s critical to maximize revenue through rent increases and ancillary income streams, such as tenant insurance and administrative fees. Owners should also minimize concessions. While property condition is important, there’s little to no consideration put on the type of construction materials used. Whether the facility is metal or block construction, at the end of the day, value is determined by NOI.

That’s why it’s important for NOI to be calculated using industry-standard parameters for other income and operating expenses. Owners who operate their own facilities often fail to include the cost of their management company or a payroll cost for themselves in their financials. In addition, there’s often an increase in real estate taxes for the new buyer that will change the NOI. These factors should be carefully reviewed when determining value. For anyone looking to buy, a self-storage facility, one of the most important things to know is the property’s true cash flow.

Without an accurate NOI, your property valuation could be inaccurate. This is critical since unexpected expenses that arise after purchase could reduce your expected ROI.

Profit and Loss

When buying a self-storage property, you need to perform due diligence before closing. This process allows you to get a complete understanding of what you’re purchasing, including any risks or issues with property condition. The most critical part is reviewing the facility’s financial records, specifically the profit-and-loss (P&L) statements, rent rolls, real estate taxes and insurance.

When examining P&Ls, review and verify all monthly revenue and expenses and match bank deposits to reported revenue. You’ll also want to compare and examine invoices and bills to confirm reported expenses. Make sure you understand the accounting methods used and capital expenditures, such as roof repairs and HVAC replacements. Keep an eye out for any inconsistencies.

Other Value Factors

Remember, there are some major fixed costs attached to a self-storage business. You’ll need enough storage space—typically at least 40,000 square feet—to support staff and meet expenses.

For a facility to experience maximum cash flow, population density is key. A location with a local population of at least 50,000 within a three-mile radius is desirable. A small town or rural community isn’t going to support a self-storage complex. Without a robust population, there’s limited demand. It’s also critical that the market not be oversupplied.

Other important factors are strong visibility and a high-traffic roadway. If a facility is easy to locate and convenient to access, customers will come.

A self-storage facility can be a lucrative investment. Once you know your way around the market and understand the key factors that affect cash flow and value, you’ll be on the road to success.

The Mele Group is the predominant self-storage advisory team for commercial property-investment firm Marcus & Millichap. Its client base consists of individual property owners, real estate investment trusts, and private institutional-level funds and firms. In 2015, the group closed 47 self-storage transactions in 11 states for more than $280 million. For more information, call 813.387.4790; visit www.melestoragegroup.com.