What is a self-storage facility worth? As the old adage suggests, it is worth what a buyer will pay and a seller will accept.
In these challenging times, even if a buyer and seller agree on the value of a self-storage facility, unless the buyer can pay cash at the agreed upon price, there may be a third party to consider into the equation—the lender. So maybe we should say a property is worth what a buyer, seller and lender all agree what it is worth.
What methodology can be used to determine a value that all the parties can accept? The two methods in this article are called the “snapshot” and “holding period.”
The snapshot is really the capitalization rate scenario in which annual net operating income (NOI) is capitalized at a rate the buyer/investor finds acceptable. In commercial real estate, investors are seeking an investment vehicle they believe will provide a risk-weighted return that is superior to alternative investments. Real estate is unique in the eyes of the law and in the eyes of buyers and sellers. Each commercial property offers a distinctive risk-reward ratio. Just like junk bonds offer a higher return but carry more risk than U.S. Treasury Bonds, so might one property over another.
In other words, a relatively new property in a growing area may present less risk and a lower capitalization rate than an older property in a declining area. Accordingly, the buyer, seller and lender must see that ratio or capitalization rate in a similar manner or there will be no agreement as to value and no sale. In the case of a refinancing, there may be no buyer but the valuation process is similar.
How do we determine value by using a capitalization rate? The first step is to look at the property, compare it with other similar property types, examine alternative investments and their associated returns, and look to the market place to determine an applicable capitalization rate is. Historically capitalization rates for self-storage properties have moved in direct relationship with long-term interest rates and the perceived risk associated with the investment.
Often, professionals can disagree as to their perception of the applicable capitalization rate and, ultimately, the marketplace determines the true capitalization rate. As of this writing, often-used capitalization rates fell between 8 percent to 10 percent.
To determine the value of a self-storage facility using the cap rate method, an investor must first determine the income the property will generate after the payment of all operating expenses. In other words, the investor has to determine the NOI of the property, which can be calculated using the following equation: Gross potential income (the amount that would be generated at 100 percent occupancy at market rents) less vacancy and credit loss equals gross effective income.
The next step is to subtract from gross effective income all operating expenses to calculate the NOI. Operating expenses include items such as real estate taxes, payroll, utilities, repairs and maintenance, management and other expenses. An abbreviated calculation would be:
- Gross potential income $450,000
- Less vacancy and credit loss $90,000
- Gross effective income $360,000
- Less operating expenses $180,000
- Net operating income $180,000
For the purpose of example, let’s assume the buyer, seller and lender all agree the annual NOI of a property is $180,000, and the appropriate capitalization rate is 9 percent. (By the way, lenders often include items such as reserves, management fees, etc., that owners don’t always consider when calculating NOI.) We can determine value by a simple formula: Income divided by capitalization rate equals value.
Calculating value•IRV = income / cap rate x value•NOI = $180,000•cap rate = 9%•value = $2,000,000
Therefore, a self-storage property with an NOI of $180,000 will have a value of $2 million at a 9 percent cap rate based on a snapshot in time.
The capitalization rate method is based on a short period of time, usually 12 months or less, and is, therefore, a snapshot. It does not take into consideration the value of a property owned over a longer period. Accordingly, another method to determine value is one that evaluates revenue and costs a property will generate over time of ownership, including the proceeds from a sale.
This holding period method uses a measurement entitled internal rate of return (IRR), which is defined as the rate of return on each dollar that remains in an investment. It is a methodology that considers the purchase price of a property, the NOI of the property over the holding period, and the sale proceeds generated from the property at the end of that period.
By way of explanation, consider two luxury cars from different manufacturers. Both may have similar purchase prices but one may include a maintenance program, offer greater safety, cost less to operate and attract a higher price upon resale. One may cost less over the period of ownership and be a better value, which would not be apparent looking just at the purchase price.
In a similar manner, two self-storage facilities may seem equally attractive and be offered for sale at the same capitalization rate, but one may offer a higher return over time than the other and, therefore, a better value. If one focuses solely on the capitalization rate method, that difference may not be apparent.
Let’s use the same self-storage property that generated a NOI of $180,000 this past year. Assuming one could buy the property for $2 million and hold it for seven years we can calculate an IRR based on a few assumptions. If we assume that revenue and vacancy grow at 4 percent per year, expenses increase at 2 percent annually and the property is sold at the end of the seventh year at a 9 percent capitalization rate with a cost of sale of 5 percent, the IRR equals 14 percent.
The very same property valued at a 9 percent cap rate as a snapshot could provide the buyer with a 14 percent return over the time the property was owned assuming our hypothesis is correct. That return could be even higher if the buyer borrowed part of the purchase price.
While this is an over simplified example for the purposes of this article, many more factors such as loan parameters, cost of capital, changing occupancy, changing expenses and revenue can be factored into the analysis. A commercial real estate professional should be able to provide a specific analysis for your property.
There is no one right way to determine the value of any property or product, but these two methods offer insight into the rationale and approach used in the commercial real estate industry. Of course, no sales transactions will occur until a buyer and a seller agree upon a value. The two mathematical methodologies discussed above should help bring together a meeting of the minds.
Dale C. Eisenman is president and broker in charge of Midcoast Properties Inc., and is a licensed real estate broker in Georgia, North Carolina and South Carolina. He specializes in the self-storage industry as an investor and a member of the Argus Self Storage Sales Network, a national brokerage organization specializing in marketing self-storage facilities. To reach him, call 843.342.7650; e-mail [email protected]; visit www.midcoastproperties.com.