In the business of buying and selling self-storage properties, the discussion for buyers and sellers always ends with capitalization (cap) rates. Unfortunately, most people don’t fully understand all the ramifications of this simple-sounding number. It’s also clear we have many new investors in the marketplace who have never bought an income-producing property and are just learning the basic math. Hopefully, this summary will help clarify this mysterious yet fundamental concept.
What Are Cap Rates and Why Use Them?
Real estate valuation is a very complex business, with many variables that affect the price. Over the years, real estate professionals found they needed a way to compare property values (price) in a market using a shorthand method, thus cap rates came into general use.
Essentially, cap rates tell an investor what he should expect to earn as a percentage if he purchases a property using all cash. For example, if an investor thinks a property is worth a 7 percent cap rate, then he expects to receive an unleveraged 7 percent cash-on-cash return.
When the net operating income (NOI) is divided by the cap rate—voila!—you arrive at a property value. This method is essentially a way to develop a price based on an income stream. The net result is the lower the cap rate, the higher the value; the higher the cap rate, the lower the value. This is only one of the three methods used by appraisers to value a property, but it’s the one most focused on by investors. It’s primarily used because it does a very good job correlating property values and helps facilitate comparison between markets.
The Underlying Assumptions in Calculating NOI
As with any good rule of thumb, there are certain assumptions that are implicit in the calculation of the NOI. For cap rates to be useful and comparable, the NOI must be calculated on a consistent basis on all properties. For example, the operating expenses must be similar in nature and somewhat standardized to compare “apples to apples.” The first assumption when calculating the NOI is that all revenue must result from reoccurring operations of the property (rental revenue) and not from an asset sale or insurance recovery.
Second, depreciation and debt service should not be deducted from revenue to arrive at the NOI. Depreciation and financing costs do not reflect value but merely tax issues and capital structure. These revenue assumptions are clearly defined and are almost universally applied.
However, assumptions related to expenses are less uniformly applied and result in significant misunderstanding, particularly among sellers. The assumptions should include that the property is properly insured and advertised in a professional way. Property taxes should be adjusted to what the new valuations will be at the time of sale.
Further, the expense numbers need to reflect the market-labor cost of running a self-storage property, which should include an onsite manager’s salary if the owner is currently doing the work for free. It’s also assumed the operating expenses include an off-site management fee over and above the onsite management expense. This will range between 4 percent and 6 percent of gross revenue depending on the size of the property.
Many owners will say some of the assumptions don’t apply to them for various reasons, but I can assure you there are almost no exceptions in the marketplace of real sales. In the end, ignoring these assumptions is, at best, self-deception and, at worst, can have serious impacts on the financing or sale of a property.
Why Do Some Properties Have Higher or Lower Cap Rates?
Since all properties are not alike, they can command different cap rates. The variations from normal cap rates (today between 6.5 percent and 8 percent) usually reflect the quality of the project and the risk to the investor. For example, a 40 percent vacant, metal-building project in a rural area would require a higher cap rate to reflect the increased risk and lesser-quality asset. On the other hand, a large masonry project with full security in a growing metropolitan area with consistently increasing rents would command a premium cap rate, perhaps in the range of 6 percent to 7 percent.
Once again, while the cap rate may vary, the underlying assumptions about the NOI do not. Property valuations are somewhat subjective, but our collective experience would indicate that knowledgeable buyers and sellers agree on the quality of the NOI and with the risk variances that lie in the very narrow range of cap rates.
Do Cap Rates Really Reflect the Market?
The answer is unequivocally “yes”! If cap rates did not reflect the marketplace accurately, we would not be using them in so many ways. The chart below will give you an idea of how cap rates have varied over the last 10 years. Please keep in mind it takes into consideration all self-storage properties around the country. Remember, a property in a small city or town will not command the same low cap rate as one in San Francisco or Midtown Manhattan.
As you can see, the market has seen a constant decline in cap rates for self-storage properties over the last 10 years, from an average of 10 percent in 2000 to 6.25 percent in 2013. This is largely due to the increased industry data now available that indicates the overall risk associated with owning self-storage is much less than once thought. Not to mention we have had a great run of low interest rates for the past decade that has also fueled the increase in value of almost all income-producing real estate, including self-storage.
However, the most intriguing metric in the chart is the spread between cap rates and interest rates, indicated by the red line. As you’ll notice, the trend is less constant than the more consistent cap-rate and interest-rate trends. The narrowing of the spreads between cap rates and interest rates today would indicate the market is realizing, once again, that the stability of self-storage income streams is very durable.
This review of cap rates provides you with the very basics of how they work and their effect on valuation. It should allow you to arrive at a ballpark value for your new investment or current self-storage property. However, you must be impartial when making the judgment call required regarding income and expenses, and then compare your project to other comparable sales in your market to arrive at an appropriate cap rate.
If you’re considering professional advice when evaluating a self-storage investment, it’s important to consult with a real estate professional who specializes in self-storage. Like any business, there are some things unique to this industry with which an average real estate professional may be unfamiliar, regardless of his other experience or intentions. Understanding and setting the value of a property is the single most important step in the investment process.
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]; visit www.argus-selfstorage.com.