A Discussion of Cap Rates

During my early career in real estate, I served as a real estate analyst for a major Wall Street institutional investor that was very focused on capitalization (cap) rates and 10-year internal rates of return (which, quite frankly, are only as good as the information and assumptions incorporated into a financial program). In the self-storage arena, I have generally found cap rates are the primary indicator of value on stabilized product.

Theoretically, a cap rate is the rate of return you could expect to get in perpetuity if you pay "all cash" for an investment, with all other factors remaining constant. The formula for a cap rate is the net operating income (NOI) divided by the price of the property. Conversely, price is determined by dividing the NOI by the cap rate.

Since my entrance into self-storage in 1992, I have seen cap rates fluctuate from 10.5 percent or 11 percent to the mid-8 percent range. In the early to mid '90s, cap rates were certainly above 10 percent and, in most instances, closer to 11 percent across the board. Transitioning into the late '90s, large publicly traded real estate investment trusts (REITs) brought the cap rates below the magic 10 percent barrier.

I vividly remember the great earthquake that took place in Northridge, Calif., in 1994, destroying homes and displacing thousands of people. It was a tragic event. Occupancy rates in storage facilities shot up to nearly 100 percent within a couple of months, just as the advent of the REITs was taking foothold. At that time, sellers received a twofold increase in the value in their facilities, one from increased occupancy, and a second due to lower cap rates paid by the REITS.

Today, it is not unheard of to find cap rates in the very low 9 percent to even a high 8 percent range. I have encountered a bit of softness in the market--from rental rate and occupancy standpoints--due to increased competition and other economic reasons; however, with interest rates on storage facilities being lower than those previously on home mortgages, you can still acquire a facility at a very low cap rate and have positive leverage.

The cap rate investors are trying to achieve is related to initial and stabilized income numbers. In many instances, initial cap rates are lower than stabilized as operators often feel they can add value to any given property based on their management expertise or economies of scale (i.e., they have other facilities in the area and can share operating expenses). However, assuming a property is fully leased--and with the exception of a normal 5 percent to 7 percent physical vacancy at market rates, with market expenses--the spread between your going-in and stabilized income will be minimal; thus, the going-in cap rate will be more reflective of the stabilized one.

On the other end of the spectrum, I have seen properties at above-market rents that are fully leased as a result of excessive rental concessions and specials. I have also seen fully leased properties with several competitors under construction, which will ultimately place downward pressure on rental and occupancy rates (in the short to midterm). In these instances, the stabilized cap rate may actually be lower than the initial; therefore, you would expect to have a higher initial cap rate at acquisition.

Nonetheless, I have never seen cap rates at this level, nor the infusion of capital from institutional investors and small, private operations looking to diversify. Assuming the debt/equity and economic markets stay relatively stable at these rates, I believe cap rates will remain relatively the same as well.

Matthew T. Pipkin is a senior vice president with Lee & Associates, Newport Beach, Inc. He has been responsible for the recent sale of more than 500,000 buildable square feet of entitled self-storage land, and the sale or escrow of more than 2 million square feet of existing self-storage facilities. For more information, call 949.724.1000; visit www.lee-associates.com.

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