Forecasting economic trends, particularly in real estate, is risky business. However, failing to pay attention to trends such as interest rates, cap rates and overall investor confidence is even riskier. Self-storage owners make or lose money because theyre in the real estate business, not the self-storage business, even though their facilities may be an extremely reliable income stream.
The value of your self-storage property is affected far more by economic trends that impact the real estate market than by operational factors. Today investors not only have capitalization-rate risk but interest-rate risk. The first thing to remember is income creates the basis for value.
In real estate, the relationship of income to value is called a capitalization (cap) rate, which is the rate of return an investor will expect on the invested equity without taking into consideration debt on the investment. If you think about the return on an investment, a low return or cap rate usually implies a higher value for the same income. Conversely, a high return or cap rate usually means a lower value for the same income. This ratio, or cap rate, is set by buyers and sellers in the market.
Property-specific and market conditions also have a dramatic effect on cap rate. Together, they determine what buyers and sellerswho often do not agree on associated riskfeel is an appropriate cap rate for an investment. Therefore, its important for self-storage owners and real estate investors to understand the risks and factors affecting value in the market. If you do the math, youll see that capitalizing market conditions will have a greater impact on an investments internal rate of return (IRR) than simply renting more units and improving facility operation.
The True Cap Rate
First, understand a cap rate is a mysterious number and changes from one property to the nextthere is no standard. When you hear someone say they bought a property on a 10 cap or sold on a 7 cap, remember many things affected those rates.
The relationship of income to value changes from asset to asset. Property-specific actors include:
- Is the property on a land lease?
- Is the market overbuilt?
- How difficult is it to develop a new project in the market?
- How many competitors are in a five-mile radius?
- Who are the competitors?
- Is the state considering a sales tax on self-storage rentals?
- Whats the quality of construction on the project?
Market conditions may have an even bigger effect on the cap rate and include such things as investor confidence, inflationary risk, interest-rate risk and the availability of financing. There simply isnt one number that can be used to value every project. Every property has its own set of risks.
Interest Rates: Whats Next?
The continuing low-interest-rate environment has had a dramatic impact on self-storage investments over the last six to nine months. The most obvious and positive effect is owners are able to sell their properties for close to historically high prices or refinance and keep a larger share of their hard-earned income by paying less to their lenders in the form of interest.
The reality is buyers are paying high prices because theyre able to borrow at somewhere between 5.25 percent and 6 percent interest, which leaves plenty of spread between the cap rates and the cost of borrowed money. As always, investors are looking to create arbitrage, taking advantage of the difference between what they can borrow and the return theyre receiving on investments. This tactic increases the rate of return on equity.
With these thoughts in mind, many investors wonder how long current interest rates will last. With the liquidity crisis of 2008 still fresh in the minds of the U.S. Federal Reserve and the ever-increasing concern about inflation, the question is when to jump.
We also wonder when the Fed and other political types will make it a priority to control inflation, i.e., raise interest rates. What we do know is as interest rates go up, prices relative to income will go down. Buyers will not purchase properties at cap rates that are less than the cost of borrowed money. Not even the best management can make that situation profitable.
Overcoming the Risks
When considering the cap-rate and interest-rate risk in the market today, you can protect your investment by ensuring you have plenty of time left on your existing loan, and the interest rate is locked or has a ceiling you feel is reasonable. Also, your ability to take advantage of perceived market conditionsfor example, selling when the market is improvingwill have a greater impact on your investments IRR than simply renting more units and improving operation.
To execute on this strategy, you must have a low or no prepayment penalty on your existing loan. As you know, its not how you get into the deal, its how you get out of it that counts. Lastly, keeping your loan-to-value in line with the depth of your resources will enable the property to make money for you rather than its leverage. Its also just a good business practice.
There are many things that affect self-storage value, and I cant begin to address all of them or even do justice to the details as it relates to the relationship of cap rates and interest rates. Hopefully, this article has given you some insight as to the risks and opportunities present in the current market.
Ben Vestal is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE; e-mail [email protected].