As a self-storage real estate professional, I find the fundamental question that seems to come up at the end of almost every business conversation is also the most difficult to answer: What are capitalization (cap) rates today? Unfortunately, most people dont understand the impact this one simple number has on the overall value of a self-storage property and, more important, what goes into arriving at an appropriate cap rate for a property.
I 'll go one step further and suggest cap rates may not be the best tool in valuing self-storage properties. In todays yield-hungry investment market, I find investors are more concerned with the cash-on-cash returns theyll receive when buying a property than with the actual cap rate.
If youre an astute real estate investor, you understand that a cap rate is one component to arriving at the cash-on-cash return. Today, a more appropriate question a buyer or seller may consider asking is what are the terms of the debt one can obtain on this property? The current aggressive debt market has caused cap rates for self-storage properties to compress to historically low levels. However, Ive recently found myself asking the question, is the property making the investor money, or is the debt making the investor money?
Taking Advantage of Pricing
While the word arbitrage is usually thought of as a high finance concept, there may be some viable opportunities that are present in todays self-storage investment market, even with historically low cap rates. The term arbitrage means an investor has the opportunity to take advantage of some pricing or other discrepancies in the marketplace.
The accompanying chart indicates why this may be possible in todays self-storage market. The green line indicates the average cap rates for self-storage properties over the last 10 years. A cap rate, in basic terms, is the unleveraged return an investor can expect without putting debt on the property. The blue line indicates the interest rate for 10-Year Treasury over the last 10 years. The 10-Year Treasury is the benchmark for most commercial real estate loans, and financial institutions will use this rate plus an additional spread to arrive at an all-in interest rate that will be offered to the borrower. The red line, then, indicates the spread each year between the cap rate and 10-Year Treasury and will give you a feel for the arbitrage buyers have been able to obtain over the last 10 years.
As you can see, the spreads shrank to around 254 basis points at the top of the real estate boom in 2006 and 2007. The spreads expanded to 531 basis points at the height financial crisis in 2009 (who can forget that?). In 2012, the spread hovered around 486 basis points, which has enabled buyers to pay very aggressive prices while generating compelling cash-on-cash returns.
Its worth noting that the average spread over the last 10 years is around 425 basis points, so todays spread of 480 basis points is in the top half over the last decade. Obviously the spread doesnt take into account the banks risk-adjusted spread, as thats administered by the bank on a deal-specific basis, but it should give you an idea of why cap rates are at historically low levels. More important, it indicates the opportunity in today self-storage investment market due to the low cost of debt.
Taking an Accurate Approach
Buyers today are able to reach cash-on-cash returns that are compelling by todays standards, all while paying very aggressive prices due to the arbitrage between cap and interest rates. Sellers today are also enjoying near historically high prices for the simple reason that a buyers ability to pay is being driven by the low cost of debt and aggressive underwriting by financial institutions.
The reality of todays investment market is the longtime fantasy of self-storage being considered a core asset and, more important, priced like a core asset is coming true. This will continue for the foreseeable future, as the self-storage fundamentals (supply and demand) are strong. One note of caution, though: Self-storage investors should be wary of new development in their markets, as developers are beginning to enter the picture once again.
Its important to understand the cap rates indicated in the chart are a broad look at the market, and it doesnt mean that every self-storage property is a 6 or 7 cap deal. Today more than ever, we need to be realistic and understand theres a bifurcation in the market between institutional-quality deals in major metropolitan statistical areas, which account for only about 10 percent of self storage properties in the entire country, and the rest of the market. The vast majority of the self-storage deals we see now are trading at 8 percent to 10 percent cap rates, and will vary significantly based on the location, quality and features of the specific property.
However, the chart does indicate why self-storage values are near historically high prices and why buyers today are still very aggressively purchasing assets. The low cost of debt and strong self-storage fundamentals have created a perfect scenario for buyers and sellers alike.
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] To learn more about cost segregation and accelerated depreciation, visit www.argus-selfstorage.com.