Price Perspective: A 3-Pronged Approach to Self-Storage Valuation Amid Market Uncertainty

If you’ve been watching the stock market, you’ve noticed that Wall Street has become more cautious with regard to self-storage investments. The four major real estate investment trusts in this industry are down about 25% on average this year, and dividend yields are moving higher as stock prices sink lower.

The general market sentiment is self-storage property valuation is difficult to pin down. No buyer wants to catch a falling knife, which has led to fewer purchases. As we head into winter after a less-than-stellar summer rental season, interest rates continue to rise while operational fundamentals soften.

One thing we’ve learned over the years is true market value is what the buyer pool is willing to pay for a property at any given time, no matter what your banker tells you it’s worth or an appraiser writes in a report. Thus, under current conditions, investors should look at all three valuation methods—income, sales comparison and replacement cost—to ensure they arrive at the most accurate number.

Income Approach

Historically, income has been the main driver of self-storage valuation, and it still carries the most weight when assessing a property. In essence, it begins by calculating the value of the unleveraged rate of return on net operating income (NOI). NOI is determined by subtracting operating expenses from total revenue. To arrive at value, simply divide the NOI by the appropriate capitalization (cap) rate (unleveraged yield).

When reviewing the underwriting and valuation of a self-storage facility, there are nuances that can be applied, for example, adjusting historical operating expenses like management fees, real estate taxes and advertising costs. You should also evaluate the most appropriate picture of revenue—trailing 12 months, trailing six months or a year-one pro forma—depending on how overall market sentiment pertains to the specific submarket and asset.

When using the income approach today, the elephant in the room is the impact of rising interest rates since most self-storage buyers use some form of debt. With rates currently around 6.5% to 7.5%, most buyers are looking for properties with stabilized cap rates at or above the current interest rates to avoid negative leverage. As a result, self-storage valuation has become more of an art than a science.

Sales Comps

The sales-comp approach to self-storage value can be the most uncertain. Over the last six to nine months, there’s been a meaningful slowdown in the transaction market, leaving buyers, appraisers and lenders with very thin historical data on which to rely.

Most buyers and lenders use this method as a “gut check” to ensure they aren’t overpaying for an asset. They want to know their price is within the range other buyers have paid when it comes to price per square foot and cap rate for a similar facility. However, this approach can get tricky, as you need to account for each property’s attributes and shortfalls to ensure you’re comparing apples to apples. For example, you need to look at unit types (climate control or ambient), quality of construction, who the operator is/was, asset age and location within the submarket.

With a lack of sales over the past year, many buyers and lenders have been forced to look further back to find truly viable sales comps. But the market has shifted since these assets were sold, which can lead to an inaccurate conclusion of value.

Replacement Cost

As the cost of construction has risen over the last five years, replacement-cost valuation has gained momentum. These days, most self-storage buyers are highly aware of replacement cost and are using it as a metric when evaluating potential investments. Core/basis buyers, in particular, are highly focused on it. This is a select group with a very long-term investment horizon, typically comprised of all-cash buyers.

Their idea is to buy properties in very desirable markets with high barriers to entry, at or slightly above replacement cost. These acquisitions will typically yield lower than market returns during the first few years but will be highly beneficial later thanks to rapidly increasing yields and an outsized reversion sale seven to 10 years down the road.

Due to the rapid rise of interest rates, inflation and construction costs, there are select situations in which a property’s NOI or pro forma NOI won’t support a valuation that income-approach or sales-comp buyers are willing or able to pay in today’s market. In addition, these properties may be “under water” using standard income valuation.

Nevertheless, replacement-cost buyers see this as an opportunity since they’re focused on the life of the investment. They look at the location and time required to build within the submarket, betting that rental rates and replacement cost will grow at an outsized pace, thus allowing them to achieve an acceptable, risk-adjusted rate of return.

To be clear, few properties have the attributes to attract a core/basis buyer, but if a seller has a newer, class-A facility in a major market and is struggling to refinance or looking to exit the investment due to partnership or personal reasons, one can see how a replacement-cost buyer might value the property.

Broker Assistance

For all the reasons we’ve discussed—rising interest rates, changing operating fundamentals and wavering investment sentiment on Wall Street—self-storage values are difficult to peg in today’s market. This is why partnering with an experienced industry broker is more important than ever. They can help buyers and sellers navigate today’s complex valuation processes.

If you’re a self-storage owner who’s at or near a “personal crossroads,” it’s time to get serious and review your property’s valuation with the help of a knowledgeable broker. Whether you’re buying or selling, it’s important to understand current market factors and the correlated nuances that create value as well as those that don’t.

Ben Vestal is president of Argus Self Storage Advisors, a national network of real estate brokers who specialize in self-storage. The company provides brokerage, consulting and marketing services to buyers and sellers via an extensive marketing platform. Property listings and informational resources can be found at the company website. For more information, call 800.55.STORE; email [email protected].