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.
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.