By Christian Sonne
Appraisal is the process of formulating an opinion of real estate value as of a given date. The appraisal itself is an economic model that analyzes all factors that bear upon the value or worth of a real estate asset, such as a self-storage facility. The problem is defined, the property described and the data involved acquired, classified, analyzed and interpreted into an opinion of value. All property is analyzed according to the highest and best use, as though it were vacant and improved.
Three primary valuation approaches have evolved in the appraisal process:
Cost approach: Considers the value of the land as vacant, plus the cost of the improvements including profit, less accrued depreciation from physical, functional and external causes
Sales-comparison approach: Considers the recent selling price of similar properties compared to the subject, broken down into common units of comparison, with adjustments being made for differences
- Income-capitalization approach: Considers the economic or contract rent (earning capacity) of the land and improvements, less vacancy and landlord expenses, with the resulting net income stream being capitalized by an investment yield or capitalization rate that would be reasonable to a prudent investor
The approach a professional appraiser uses depends on the type of property, the availability and suitability of the market data on which the approach is predicated, and other judgment factors. The use of two or three approaches will generally result in a range of values for the subject property. Those values are then correlated to a final value conclusion. This article emphasizes and analyzes the sales-comparison and income-capitalization valuation approaches to self-storage real estate.
Sometimes called the market approach, the direct sales-comparison approach involves investigating recent sales of similar self-storage properties and comparing them with the subject facility. Its based on the premise that an informed buyer would pay no more for a facility than the cost of acquiring an existing property with the same utility.
The weakness of the approach lies in accurately accounting for the variables among self-storage building sales. For example, as a test of reasonableness, several tools of analysis are warranted. On this basis, the sales-comparison approach is generally given secondary consideration in the final value conclusion. The accompanying table, "Summary of Improved Self-Storage Sales," presents a brief analysis, beginning with comparable sales data.
The data analysis centers around property and transaction characteristics affect the price of real estate. According to The Appraisal of Real Estate, 13 Edition, produced by the Appraisal Institute, there are 10 common elements of comparison that should always be considered in the sales-comparison analysis. They are summarized in the table below.
The sales data indicates a value range from $35.13 to $57.60 per square foot, with an average of $45.28. Two units of comparison are used in this analysis: the effective gross income multiplier (EGIM) and an adjustment grid. Both value indications are correlated to a final estimate of facility value under the sales-comparison approach with a comparison to the range of price per unit and price per square foot from the data set.
The sales used in this analysis were the best available comparables to the subject property. The major points of assessment are:
- Property rights conveyed
- Financial terms incorporated into the transaction
- Conditions or motivations surrounding the sale
- Changes in market conditions since the sale
- Location of the real estate
- Physical traits of the property
- Economic characteristics of the property
We've made a downward adjustment to those comparables considered superior to the subject facility and an upward adjustment to those comparables considered inferior. Where there expenditures upon sale, they've been included in the sale price. It's very difficult to accurately derive a dollar or percentage adjustment for each variable. For example, the data shows a value range (unadjusted). Further, the data does not specifically demonstrate adjustments for all the variables.
This technique compares each sale to the subject facility based on the net operating income per square foot of rentable area. This results in an absolute difference, accounting for all the variables, in terms of one percentage adjustment. This absolute percentage variance between the comparable and the subject is directly applied as a net adjustment to the price per square foot. The analysis is summarized in the tables, "Improved Sale-Adjustment Grid" and "Percent Adjustment Method Summary."
View "Improved Sale-Adjustment Grid."
The EGIM is calculated in the transactions by dividing the sale price by the effective gross income (EGI) at the time of sale. All other things being equal, the lower the income, the lower the sale price. However, there are other variables that affect the price/income relationship such as the condition of the property, the vacancy at time of sale, the stability of the income stream, the likelihood of near-term change (up or down), and the ratio of operating expenses to EGI.
As all of the sales are very similar to the appraised property in terms of physical condition, access and visibility, and the prospect for continuation of the income stream at or near current levels, the expense ratio is the most significant variable of difference. It affects net operating income and, by implication, the overall capitalization (cap) rate and sale price. The higher the expense ratio, the lower the EGIM.
As support for this EGIM, we've checked it against our concluded cap rate of 7.75 percent and the subject facilitys estimated expense ratio of 37.49 percent.
- Equation: 1 - [Expense Ratio / Cap Rate] = EGIM
- Calculation: 1 - [37.49% / 7.75%] = 8.07
Based on this calculation, we conclude the indicated value by the analysis to be as displayed in the following "EGIM Summary."
View "EGIM Summary."
In conclusion, the two indications of value for the subject sales-comparison approach are:
- EGIM: $3 million
- Price-per-square-foot analysis: $3.2 million
The income-capitalization approach considers the market value of the subject property from the perspective of a typical investor. In this regard, direct capitalization reflects the market. It demonstrates the expectations of the market based on a static (stabilized scenario) cash-flow model. Therefore, the income-capitalization approach conclusion is given primary emphasis in the final value conclusion to be consistent with the self-storage investment market and most probable buyers.
The potential gross income consists of rental and other income. Rental income is derived from the self-storage units. The only reliable way to calculate it is by individual unit as outlined in the table, "Market Rent Forecast - All Units." Analyzing rent per square foot can be very misleading and cause erroneous results because rental income is dependent on the unit mix.
View "Market Rent Forecast - All Units."
Ancillary income includes late fees, administrative fees, retail sales, truck rentals and other miscellaneous items. It's typically 2 percent to 5 percent of gross income. In our example, other income is derived from all these sources except truck and equipment rentals. The forecast rent roll, detailing potential gross income, is summarized in the table.
Vacancy is comprised of three main components: stabilized or physical vacancy, collection loss or credit, and concessions. In the subject analysis, all three are combined to form a long-term vacancy factor. Considering the subject facility's competitive position and typical turnover, a physical-vacancy factor of 20 percent is concluded. As to credit loss, the market will remain over supplied. This prediction is consistent with the forecast of market equilibrium, long-run vacancy trends, and the subject competitive position within the market.
The subject self-storage facility operates on a full-service or gross basis, meaning all operating expenses are paid by the owner, including fixed and variable expenses. Fixed expenses do not vary with occupancy and include real estate taxes and insurance. Variable expenses vary with the level of occupancy. They include repairs and maintenance, administration, on-site management, off-site management; utilities, advertising, and miscellaneous.
Self-storage property rarely incurs reserves for replacement in direct capitalization. Due to a relatively low breakeven point with respect to occupancy, self-storage expenses tend to be relatively inelastic or stable (in terms of total amount).
An expense forecast should be based on the market. Historical expenses should be analyzed in relation to the market and can be arrayed in a graph to illustrate variances. In the current market, buyers are particularly cautious about tax risk at the time of sale and adjust for market-based management expenses.
Overall Cap Rate
The overall cap rate is calculated by dividing the net operating income by the sale price. According to The Appraisal of Real Estate, 13th Edition, the basic direct-capitalization formula can be described as IRV or I/R = V, where I is income, R is cap rate and V is value. Ideally, the overall cap rate is selected from the market through sales of similar properties. Several techniques are summarized in the "Cap-Rate Conclusion" table.
Direct capitalization considers the income from one stable year of operation of the subject facility and capitalizes it into an indication of value. Under these parameters, the direct capitalization and the income summary are detailed in the tables, "Stabilized Year for Direct Capitalization" and "Prospective Value Upon Stabilization."
View "Stabilized Year for Direct Capitalization" table.
Discounted Cash-Flow Analysis
Due to increasing sophistication in the self-storage asset class, discounted cash-flow (DCF) analyses are being used more by investors. This involves a forecast of cash flow over a typical holding period (usually 10 years). It's ideal as a tool of projects in absorption because the DCF analyzes as is and prospective stabilized scenarios. For the subject self-storage facility in our example, this analysis is presented in the following table.
Correlation to Final Value Conclusion
The significance, applicability and defensibility of each approach conclusion are weighted in the determination of the final value conclusion. On this basis, the value conclusions from the three approaches are summarized in the "Final-Value Reconciliation" table.
View "Final-Value Reconciliation" table.
A powerful economic model, an appraisal is an excellent tool to determine the value or worth of an individual self-storage asset. Appraisal is complex and requires experience to understand and use properly, although the model is simplified for illustration in this example. As the self-storage asset class has risen in sophistication, so must the tools to analyze the market.
Christian Sonne is the executive managing director of the Self Storage Industry Group of Cushman & Wakefield, which offers facility valuations, industry analyses and investor surveys. Prior to joining C&W, Chris was a real estate appraiser serving financial institutions, government agencies, industrial and commercial firms, the legal profession, and the development industry. He has been a featured speaker at many self-storage conferences and is author of the Self Storage Economics and Appraisal seminar sponsored by The Appraisal Institute. To reach him, e-mail [email protected] .