How do you judge the fairness of an appraiser’s value and selected cap rate? The use of an “effective gross income multiplier” can help self-storage facility owners better understand their facility’s worth.
I recently visited my friend Bill, who owns a self-storage facility. When I walked into his office, he was sitting behind his desk, looking like he’d just seen a ghost. When I asked what was wrong, he said, “My loan is coming due, and I just talked to my lender. He said that since revenue has declined and cap rates increased, I’ll have to come up with $500,000 in additional equity to refinance.”
When I asked how the bank estimated the amount of equity he would need, Bill said it was based on the appraiser’s estimate of market value, and he’d sent the lender his most recent profit-and-loss statement. I asked if the appraiser had met with him to go over the data and inspect his facility. The appraiser hadn’t, but the lender gave him a copy of the appraisal. “I’ve lost everything,” Bill said. “My retirement nest egg is gone. I don’t know what I’m going to do!”
A Valuation Technique
There are many self-storage owners in this same situation. Clearly Bill and others like him need some way to check on the reasonableness of an appraiser’s judgment. How can they know if the value the lender comes up with is a fair one?
There’s a simple valuation technique used for other types of real estate that could help. Called the effective gross income multiplier (EGIM), the technique provides a quick and reliable estimate of value. It would give owners an idea of their facility value, some indication of whether there is a problem and, if so, just how big it might be. It would also allow an owner to judge the reasonableness of the appraiser’s selected cap rate.
I told Bill we should look at his appraisal, specifically the appraiser’s estimate of his effective gross income (or revenue, as it is often called). There are a few items that can really influence value, and estimating the EGI is one of them. We’d have to keep in mind that in a declining market, appraisers tend to be conservative, often focusing on a facility’s most recent performance and sometimes ignoring the not-so-obvious.
An appraisal is just an opinion of value based on a series of judgment calls that starts with the estimate of gross income and concludes with net operating income. Estimating EGI is not easy, as it begins with an analysis of the competition. This usually turns up a wide range of rental rates for each unit type.
To encourage a more accurate appraisal, talk to the appraiser about how you set asking rental rates. For example, if you set rates at the low end of the range offered by competition because you don’t wish to offer huge concessions, make sure the appraiser understands this. Otherwise he might use your existing rates, and then deduct the typical cost of concessions in other facilities, thus penalizing your facility. Explain your management style and how your facility differs from others.
A Revenue-Management Tool
One of the best ways to estimate EGI is to track total monthly collections per occupied square foot over the past 12 to 24 months. This includes rental as well as ancillary income. There are at least two benefits for doing this monthly. First, it offers a quick way to judge the fairness of the appraiser’s estimate. Second, it helps owners measure the impact of changes in rates, physical occupancy and concessions on total revenue.
This revenue-management tool was first used by the hotel industry and is often referred to as “revenue per available room,” or REPAR. The real estate investment trusts use a similar methodology for tracking revenue called “revenue per available square foot.”
While it sounds complicated, it isn’t. It’s simply the facility’s total monthly revenue divided by the number of occupied square feet for that month. In Bill’s case, his facility has 53,874 net-rentable square feet. Assuming the physical occupancy was 85 percent and the total month’s revenue was $27,873, the EGI per occupied square foot for that month was 60 cents.
- 53,874 square feet x .85 = 45,793 square feet
- $27,873 divided by 45,793 = $0.60 per square foot
The graph titled “Trend in Effective Gross Income per Occupied Square Foot” plots Bill’s monthly EGI (blue line) and the one-year moving average. Notice that even though revenue has declined, Bill has actually collected more per occupied square foot by adjusting asking rental rates, concessions, discounts and promotions. His EGI has averaged about 60 cents per square foot over the past year. We can now estimate Bill’s EGI at approximately $329,700.
- $0.60 x 45,793 square feet = $27,475
- $27,475 x 12 months = $329,709
A Valuation Tool
The EGIM is a handy tool to estimate value, and it’s easy to use. The advantage of using it is you don’t have to analyze operating expenses, only the amount of EGI. The multiplier is derived from the market by dividing the sales prices of recently sold self-storage facilities by their annual EGIs.
An analysis of more than 1,500 facility sales in my company’s database over the past several years shows EGIMs ranging between 5.5 and 9.5 (excluding extremes). EGIMs reflect investors’ anticipated risk and return and, like cap rates, have declined considerably over the past year. My analysis of EGIMs between 2007 and today indicates a peak at something over 9.
The selection of an EGIM should be based on recent local sales of comparable facilities. A quick check of sales in Bill’s market indicated EGIMs between 7.5 and 8.5, so we used 8. Having already estimated his annual EGI to be $329,700, we were quickly able to approximate his facility value at $2.6 million.
$329,700 x 8.0 = $2,637,600
Now Bill has some idea of what his facility value might be after a full appraisal is complete, and he’s in a better position to discuss his opinions with his lender. Bear in mind, this is not a substitute for an appraisal, but rather a starting point for an intelligent discussion about value.
EGIM as a Predictor of Cap Rates
There’s a relationship between EGI and cap rate, expressed by the following formula:
(1 - Expense Ratio) / EGIM = Cap Rate
If you’re not sure what the cap rate should be, you can use a range of EGIMs from sales in your neighborhood to derive a range of cap rates and see if the appraiser’s selected cap is within a reasonable range. Assuming EGIMs range between 7.5 and 8.5, as in Bill’s market, the cap-rate range would be:
- (1 - .35) / 7.5 = 8.7%
- (1 - .35) / 7.7 = 8.4%
- (1 - .35) / 8.0 = 8.1%
- (1 - .35) / 8.2 = 7.9%
This exercise indicates that if the EGIM is based on local sales, and the operating expense ratios were taken into account when calculating the EGIM range, the appropriate cap rate would range between 7.9 percent and 8.7 percent, all else being equal.
In Bill’s case, we concluded the appraiser was too conservative on the estimate of EGI. We also concluded the cap rate of 9.5 used in the appraisal was well outside the indicted range.
Get a Ballpark Estimate
The use of an EGIM is no substitute for having a compete appraisal, but if performed properly and with good data, it can provide a ballpark estimate facility value based on something other than the owner’s bias. An EGIM also allows for a fairness check on the appraiser’s cap rate. It’s important to compare apples to apples, and ensure the multiplier is applied to an estimate of EGI that reflects the facility’s historical performance trend.
The EGIM technique is just another tool, not a substitute for conducting a full appraisal. However, it does provide a logical starting point for a discussion of value that’s not just opinion-based.
Charles Ray Wilson is the founder of Self Storage Data Services Inc., an independent research firm that maintains the nation’s largest database of self-storage operating statistics. He is an internationally recognized leader in providing independent research on the self-storage industry. For more information, visit www.ssdata.net.