By Dale C. Eisenman
Self-storage owners frequently want to know, What are current cap rates? What theyre really asking is, What are our properties worth in todays market? Before we can answer that question, we need to understand two things: First, the commercial real estate market is dynamic, and second, self-storage does not exist in a vacuum.
To determine the value of a self-storage property, you must understand the income it has already generated and what it will provide moving forward. While appraisers typically value commercial real estate by the income approach, the replacement-value or -cost approach, or the comparable sales approach, this article will focus on the income approach, for this is what motivates buyers almost exclusively. Property condition, location, competition and other factors all enter into how a facility performs.
The Commercial Real Estate Market
Just like the stock market, the market for commercial real estate is constantly changing. For example, assuming a stable supply of self-storage properties for sale, from time to time, theres more capital available on favorable terms than others, which may lead to more demand, more activity and higher prices. Other times, theres less available capital (debt and equity), which may lead to less demand and lower prices.
For most investors, commercial real estate represents a financial investment and should be seen in financial terms. Buyers are looking for an adequate return as compared to alternative assets. More specifically, the self-storage buyer is seeking to achieve acceptable return as he compares specific properties.
Self-storage should not be seen in a vacuum. It competes with multi-family, office, industrial and retail real estate in its attempt to attract buyers. It also competes with alternative investments such as stocks, bonds, CDs, etc. Investors seek adequate return on their capital. Its of no importance to them what the seller has invested in the project or the proceeds he needs to fund his retirement. The asking price needs to be supported by the income the property generates.
Likewise, todays buyer will not pay the seller for future improvement in income. In fact, in this market, buyers assign little or no value to expansion land or vacant units. An existing facility may be sold below its replacement cost and, possibly, below the investment made by the current owner. Why? Because a buyer will only pay an amount he feels will be justified by the expected return.
Think of it in terms stocks: Just because someone paid $55 per share for a stock last year doesnt mean a new buyer will pay $55 or more for it this year. While its sometimes difficult, to determine a facilitys current value, an owner must focus on the return on investment his property will provide.
The process of determining self-storage facility value can be seen as reviewing the past and predicating the future. The first step is to gather and review information. Accurate records are critical. Begin by collecting: trailing 12 months revenue and expenses (categorized by month), the previous years income statement, earlier income statements, and occupancy information.
Often times, small or individual operators understate and under record revenue and overstate expenses. While there may be business or tax reasons to do so, for the purposes of determining value, you must be able to review and verify all revenue generated by the facilityrent, truck-rental commissions, retail sales, late fees, administrative fees, etc.
Equally important is to properly and accurately reflect all operating expenses. These are the costs the owner incurs to generate revenue, minus debt service, amortization and depreciation. Owners often fail to recognize items such as repair and maintenance costs, complete payroll, and others. In other cases, they include items that have nothing to do with operating the facility, which must be adjusted to provide a true and accurate picture of expenses associated with the property.
By comparing financial data month to month, the owner and potential buyer can see revenue and expense fluctuations. In many parts of the country, self-storage rentals are seasonal, as are some expenses. Comparing the last two or three years of data will illustrate trends for the property. A site that sees increasing occupancy, revenue and income is more attractive than one that shows a consistent decline.
Once armed with accurate historical information, you can attempt to predict the future. Based on experience and your view of the market, including the overall economy, you can project expected revenue by asking: Will occupancy increase? Will rental rates rise or fall? Are there missed opportunities for additional revenue through fees, truck rentals, retail sales or ancillary services? You can also project expected expenses by asking: Will real estate taxes increase upon sale? Will payroll be less or more? Will bank fees, insurance and management fees rise or fall?
This entire exercise is an attempt to determine the accurate net operating income (NOI) or revenue less operating expensespast, present and future. While buyers may project future income, they determine current value by using current NOI.
Heres a caveat: While many seem to focus solely on capitalization rates (cap rates), this is only a starting point and should not be considered a complete or full estimate of value. There are many factors a cap-rate analysis doesnt take into account, so it should serve merely as one piece of the puzzle. Cap rate focuses on NOI over a short period of time as opposed to the entire period of ownership. Once NOI is determined, including the future proceeds from sale, we can initially estimate value by using the formula:
Value x Cap Rate
If you know any two of the variables, the formula can be solved for the unknown. For example, assume a property of 50,000 rentable square feet is 85 percent occupied and generates an average of $1 per square foot per month in rental revenue. (For this example, well ignore ancillary income, which may carry a different cap rate.) The monthly revenue is 85 percent of $50,000, or $42,500; thats $510,000 per year. If operating expenses total $200,000 annually and the market cap rate is 9 percent, the value calculation would be:
- $510,000 Revenue - $200,000 Expenses = $310,000 Income
- $310,000 Income / .09 = $3,444,444
Who or what determines the cap rate? The short answer is the market. Often its the threshold a potential buyer must attain before acquiring a property. For example, a buyer may have investors to whom a 7 percent return is paid. In that case, that buyer would rarely be able to acquire a property unless he purchased at a cap rate above 7 percent (unless the buyers analysis showed adequate return in the future to offset the difference).
In other words, market cap rates reflect what buyers are willing to pay, sellers are willing to accept, and lenders are willing to underwrite. That is correctlenders play a growing role in influencing the market. If a buyer cannot finance a property at a specific purchase price, a transaction is unlikely to occur. There has to be adequate cash flow from the property to service the debt and meet the lenders requirements for, among other parameters, debt-coverage ratio and debt yield. In short, there has to be enough cash flow to pay all the operating expenses, service the proposed debt and have money left over.
Other Methods to Determine Value
There are other methods for determining facility value, and its important to be aware of them. Heres a brief summary:
Internal rate of return. This analysis calculates the rate earned on each dollar that remains in an investment every year, and takes into account the proceeds from the sale of the asset. It can be calculated based on purchases with or without financing. One of its advantages is it provides a measurement of the return one might expect over time, usually years.
Cash-on-cash return. This is a measurement of the return on the cash invested in a property and is calculated by dividing annual cash flow by the amount of cash invested.
Heres another caveat: Each approach to valuation typically ignores the impact of taxes and is, therefore, before tax. A complete analysis should take into account the tax implications for a buyer and seller based on their specific circumstances. All of these methods of valuation can be employed when estimating value.
Dale C. Eisenman is president and broker in charge of Midcoast Properties Inc., as well as a licensed real estate broker in Georgia, and North and South Carolina. In addition to being a professional pilot early in his career, Eisenman has practiced law, owned and operated several small businesses, and has been an active commercial real estate investor for more than 20 years. He specializes in the self-storage industry as an investor and broker. To reach him, call 843.342.7650; e-mail [email protected]; visit www.midcoastproperties.com .