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Understanding Capitalization Rates: Calculating Value in Today’s Self-Storage Market

By Ben Vestal Comments

In the business of buying and selling self-storage properties, the discussion always ends with capitalization (cap) rates. Unfortunately, most people don’t fully understand all of the ramifications of this simple-sounding number. We have many new investors in the marketplace who’ve never purchased a storage property and are just learning the basics with regard to underwriting. Hopefully, this summary will help clarify the fundamental concept.

What Are Cap Rates and Why Use Them?

Real estate valuation is a very complex business, with many variables that affect price. Over the years, real estate professionals found they needed a way to compare property values in a market using a shorthand method, thus cap rates came into general use.

Essentially, a cap rate tells an investor what he should expect to earn as a percentage if he purchased a property using all cash. For example, if he thinks a property is worth a 7 percent cap rate, then he expects to receive an unleveraged 7 percent cash-on-cash return. However, we all know that operating expenses vary from one facility to the next.

Often these variances lead to a deal having three different cap rates: the one the seller is using, the one the buyer is using and the one the broker is representing. These rates are typically pretty close, but with the reassessment of real estate taxes and the increased operating expenses being faced by many institutional operators, a cap rate quote can be misleading.

When the net operating income (NOI) is divided by the cap rate, you arrive at a property value. This method is essentially a way to develop a price based on income stream. 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 good job correlating property values and helps facilitate comparison between markets.

Underlying Assumptions in Calculating NOI

As with any good rule of thumb, there are certain assumptions that are implicit in the calculation of 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 all revenue must result from reoccurring operation of the property (rental revenue), not from an asset sale or insurance recovery. Second, depreciation and debt service shouldn’t be deducted from revenue to arrive at the NOI. Depreciation and financing costs don’t reflect value, but merely tax issues and capital structure. These revenue assumptions are clearly defined and almost universally applied.

However, assumptions related to expenses are less uniformly applied and result in significant misunderstanding, particularly among sellers. They should include that the property is properly insured and advertised in a professional way. Property taxes should be adjusted to reflect what the new valuation will be at the time of sale.

Further, the expense numbers need to reflect the market-labor cost of running a self-storage property, which should include an onsite manager’s salary if the owner is currently doing the work for free. It’s also assumed that the operating expenses include an offsite management fee over and above the onsite management expense. This will range from 4 percent to 6 percent of gross revenue depending on the size of the property.

Many owners will say some of the assumptions don’t apply to them for various reasons, but I can assure you there are almost no exceptions in the marketplace of real sales. In the end, ignoring these assumptions is at best self-deception and, at worst, can have serious impact on the financing or sale of a property.

The Case of Higher or Lower Rates

Since not all properties are alike, they command different cap rates. The variations from normal cap rates (between 5 percent and 8 percent today) usually reflect the quality of the project and risk to the investor. For example, a 40 percent vacant metal-building project in a rural area would require a higher cap rate to reflect the increased risk and lesser quality asset. On the other hand, a large masonry project with full security in a growing metropolitan area with consistently increasing rents would command a premium cap rate, perhaps in the range of 5 percent to 6 percent.

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