By Bill Alter
In countless articles written by self-storage experts over the years, it has been drummed into our heads that property value is determined by capitalizing net operating income (NOI). The formula is NOI divided by capitalization (cap) rate equals value. The concept to remember is the lower the cap rate, the higher the value.
Cap rate is the yield on an investment, on an all-cash basis. Why is it some investments sell with lower yields and others must offer higher? There must be some logic to that phenomenon, but what is it?
The mystery is who determines the cap rate and how. Will buyers, sellers, appraisers and lenders all use the same cap rate for a particular property? Why do cap rates vary from property to property and market to market? The answers to these questions make you appreciate the subjective components that go into determining property value.
Property value is not simply NOI divided by cap rate, but rather a blend of the current snapshot and the prospect of future growth, which is subjective and varies with investor imagination and skill. Its more of an art than a science. Heres the question that needs to be answered: Is the net income from this property likely to increase over time and at what rate?
This article discusses factors that go into determining the quality of a particular investment as it compares to other (apparently) similar investments. The astute self-storage investor is aware of these subtle influences on value and understands how each one might justify a lower cap rate or require a higher one.
To arrive at an accurate, fair value for a self-storage property, especially when it is in a city or state with which you are not familiar, it's often necessary to conduct an in-depth investigation of the property and its market. Ask questions of the brokers involved in the transaction and the seller himself. Ask about the city and the submarket.
When considering what the cap rate should be, you must know and understand how asking prices are being determined for similar for-sale properties in the market. Here are some things to consider:
- What are the asking cap rates in this market?
- How do the other properties compare to the your prospective property?
- Are the rents and economic vacancy nearly the same?
- Do the operating expenses of the other facilities for sale include approximately the same line items as your prospective property?
- Are the expense amounts roughly the same?
- Will those amounts go up or stay the same when you own the property?
You must also know and understand recent sales in the market. What has actually sold? What were their cap rates, and how were they underwritten?
You must also know if the city and your specific submarket is growing in population and at what rate. Can you expect that growth to enable occupancy and rent increases? Lower cap rates are justified if you can safely expect population growth to provide consistent increases. The reverse is also true: Higher cap rates are required if the market is oversupplied, creating a situation where it could be a long time before revenue increases.
Competition and Property Condition
Competition and Property Condition
Be aware of any possible new entrants to the market or expansions to existing self-storage facilities. Are there vacant land parcels in the area that could allow for new competitors? If so, maybe the cap rate on your prospective property needs to be a little higher to offset that risk. Ask your broker and the seller if theyre aware of any new facilities in the pipeline. They will usually know.
Also consider the existing competition and the physical condition of your prospective property. How does this property compare to others in terms of location, age, curb appeal, security and amenities? Is there any economic obsolescence? What about deferred maintenance? How are the roofs and asphalt? Find out from local contractors how much it will cost to repair physical and structural issues or install improvements that will allow the property to compete successfully in the future. If these issues are minimal, it's not necessary to push the cap rate quite so high.
Is there any room for expansion on the site? This can be in the form of vacant land included with the purchase or land now being used for RV or boat parking. Expansion potential is a good thing because when operating expenses are already covered, virtually every dollar of new income goes directly to your bottom line.
Marketing is an essential part of a self-storage facility's overall success. You should know going into the sale what the current owner is doing in this area. Does the facility have a website? Is it well-optimized so it comes up near the top of all the searches? Are you able to improve on what the seller is doing? You might accept a lower cap rate if you can improve these results without breaking the bank.
All these items need to be considered and factored into your determination of which cap rate is required for a specific acquisition. Dont go into any sale blindly. Ask questions, consider your options, then make the best decision to ensure your investment offers the rewards you seek.
Bill Alter has been a self-storage specialist with Rein & Grossoehme Commercial Real Estate in Arizona since 1986. He has been responsible for the sale of more than 100 storage facilities, totaling more than 5,500,000 square feet and more than $200 million. He can be reached at 602.315.0771; e-mail [email protected].
Using Direct Capitalization to Estimate Facility Value
By Charles Ray Wilson
Though self-storage facility values have declined since their peak in 2007, the industry has outperformed all other real estate types during the recession, and that has once again garnered the attention of investors. Self-storage as an industry is also becoming more transparent. Econometric models designed to measure supply and demand have improved, which allows investors to feel more comfortable with their risk-assessment calculations.
Key industry brokers, property owners and managers still use direct capitalization and discounted cash flow as primary tools of the income approach to estimating facility value. They use the sales-comparison approach as support. For the purposes of this article, I'll focus primarily on direct capitalization as a method for determining value.
While there has been some pretty dramatic changes in self-storage operating performance, i.e., declines in occupancy and rental rates, greater use of concessions, etc., the method investors and appraisers use to estimate facility value has not changedonly the depth and sophistication of the analysis. The value of all real estate is still the present worth of future cash flow.
Thus, the appraisers job is to assess the local market conditions that will influence a property's future net operating income (NOI). An analysis of these conditions is the foundation on which an objective opinion of value can be reached.
The basis of direct capitalization starts with making an estimate of the facility's potential gross income, which involves a detailed analysis of asking and actual rental rates by unit type compared to competitors in the local market. Then an estimate of the stabilized vacancy is made, based on the current supply of competitive units in the market. Vacancy is comprised of three main components: stabilized physical vacancy, collection loss and concessions.
Next, the appraiser must estimate total operating expenses, which typically include:
- Real estate taxes
- Property insurance
- Repairs and maintenance
- Onsite management
- Offsite management
NOI is derived by subtracting vacancy and operating expenses from the estimate of potential gross income. Its then capitalized into a value estimate by dividing it by the cap rate. The appraiser must select an overall cap rate that reflects facility quality and location and the risk of its future performance.
Investors consider the gap between class-A and -B self-storage facilities to be much smaller than the gap between class-B and -C properties. Cap rates for stabilized, class-A assets can fall below 7 percent, but tend to hover near the low to mid 7 percent range for class-B assets. The market generally indicates that overall cap rates for class-B assets are 25 to 50 basis points higher than class-A assets. For class-C assets, the spread increases to as much as 100 basis points. Thus, class-C cap rates can be 8.5 percent or higher, depending on quality and location.
Cap rates have been declining, and cap and yield rates continue to decline, according to the most recent self-storage investor surveys by PricewaterhouseCoopers (formerly Korpacz). With new capital (equity and debt), cap rates have decreased 45 basis points to an average of 7.3 percent (stabilized) from one year ago.
The accompanying direct-capitalization model assumes the self-storage facility is operating at its long-term level of economic occupancy. If the facility is not stabilized, the appraiser must estimate the value of the rent loss between today's level of performance and stabilization, and then deduct that amount from the stabilized value estimate.
Though good-quality, stabilized facilities are in the most demand, limited available product has caused some investors to consider the purchase of unstabilized, lower quality" or value-added assets. This is bringing more focus on facility classification as it relates to investment risk.
Self-storage investment conditions have improved significantly over the past four years as a result of the industry's outstanding performance. Public and private real estate investment trusts as well as large national and regional companies are competitively bidding on the limited supply of available investment-grade sites. Investor demand for good-quality, stabilized facilities is pushing cap rates down and values up to near pre-recessionary levels in many markets.
Charles Ray Wilson is the founder of Self Storage Data Services Inc., an independent research firm that maintains the nations largest database of self-storage operating statistics. Hes an internationally recognized leader in providing independent research on the self-storage industry. For more information, visit www.ssdata.net.