Sale and Valuation Terms Defined

By Michael McCune

After attending many conferences and having fielded questionsfrom literally hundreds of buyers and sellers of self-storage allover the United States, we have begun to realize that there is areal communication problem in how specific terms are definedregarding the sale and valuation of self-storage facilities. Withthis in mind, we decided to clarify a few specific terms that areused most often.

Net Income

All income, which includes rentals, sales, interest, latefees and truck rentals, if applicable, minus all expenses, whichincludes all operating expenses, depreciation and interest.

This is an "official" accounting term that is usedby CPAs and the IRS, but not much by the rest of us when tryingto understand the business operations.

Net Operating Income (NOI)

Actual income minus all operating expenses for facility(but not debt service, depreciation or interest.)

Ideally, this number tells us how well the property is doingjust from operations--not from financing or from accountingrequirements. This is the first number a potential buyer willlook at when he reviews the financial statements. One hundredpercent of the time, a potential buyer will mentally adjust thisnumber to reflect his interpretation of the validity for some ofthe expenses shown on the statement. For example, sellers mightnot pay themselves a salary or off-site management fee, as theymanage the property themselves. The potential buyer could be anabsentee investor, and need to hire not only a manager to run theproperty, but also pay a third-party management company to workthe books of his whole portfolio. He will adjust the NOI toreflect this added expense to his analysis of the property.

Cash Flow

Actual income minus operating expenses and debt sevice.

This term is best described as the "cigar box"number. This is the amount you would have left in the cigar boxif all the cash income went in it and all of the expenses werepaid in cash out of the box. I think this is the most importantnumber to our spouses and kids because it represents"spendable" income before your income taxes are paid.

Capitalization Rate (Cap Rate)

A cap rate is the result of converting an income streaminto a single capital value or an estimate of present worth(value). The capitalization rate is derived from consideration ofmarketability, liquidity preference, time preference and risksassociated with uncertainty of the future.

Everybody uses it--what is it? Some people would say thatreal-estate brokers use the term to just look smart. And whileanything along those lines would be helpful, the term is meant tobe a short-cut to discuss and analyze relative value in themarketplace for competing investments. The term "caprate" encompasses the potential return to the buyer on aperfect property that includes factors such as risk, marketcycle, level of maintenance, location, etc.

Let's assume that a brand-new, fully leased property with allthe bells and whistles in the best area of town required a 10percent return to the investor to induce him to buy the property.The cap rate would be 10--not 10 percent, just 10.

Another property of lesser quality and not exactly in the bestlocation is also for sale. Would the buyer be willing to earnonly a 10 percent rate on this property when he could buy theclass A property for the same rate? Of course not. He would wanta higher return because of the risk and quality of the property.After a careful analysis of competition and the market, the buyerdecides that he should earn 11.5 percent on the older property tocompensate for the differences between the new, class A propertyand the older property. That would mean that the valuation wouldbe based on say an 11.5 cap. The seller of the class B propertywould need to be willing to accept the buyer's analysis and livewith a lower price per foot and sales price.

The term is obviously very subjective, and the exactinterpretation may depend on whether you are a buyer or seller.But it is a convenient way of lumping a lot of intangibles intoone number. Currently, cap rates for self-storage facilitiesaround the country range from 9.5 to 12, with most falling intothe 10 to 11 range.

Value

What your property is really worth for financing or a sale.

Appraisers will tell you that market value is determined bycomparing three approaches to value: cost to replace or rebuild,market comparable sales, and the capitalized value of the incomestream from the property. Oddly enough they are right, but formost buyers and sellers, more reliance is put on the capitalizedvalue of the income stream. To obtain an estimate of value youcan take the NOI and divide by a cap rate in the 11 range,assuming there are no extraordinary items related to theproperty. Of course, there are many other factors that contributeto the ultimate value and thus, checking the indicated value of aproperty with a professional broker or appraiser should helpdetermine the final value.

Mike McCune is president of Argus Self Storage SalesNetwork, a nationwide network of brokers specializing inself-storage properties. Based in Denver, Mr. McCune may bereached at (800) 557-8673.