A capitalization (cap) rate is used in commercial real estate to show the rate of return an asset such as a self-storage facility might generate if purchased. It’s determined by dividing net operating income (NOI) by current market value. In short, it’s a measure of risk. An investor can use it to determine what they’re willing to pay for a property.

Where it gets tricky is NOI, which is income from all sources minus all reasonable and necessary operating expenses. What falls into that category can be confusing. Let’s take a closer look to help you understand what a cap rate is and how it can be used effectively.

The Income Side

For simplicity, think of the cap rate as a backward formula. For example, let’s say you won $5 million in the lottery and want to invest it. You’re hoping to earn an additional $400,000, so you’re aiming for an 8% return ($400,000 / $5,000,000 = .08). A cap rate works in the opposite direction. Let’s say you’ve found a property in which you’re interested and need to determine how much you’re willing to pay. It has strong cash flow of $400,000. If you’re happy with an 8% return or better, that means you can pay up to $5 million for the asset ($400,000 / .08 = $5,000,000).

The most important question here is what are we capping? If the asset has cash flow of $400,000, how was that number reached? You’ll likely get a different answer depending on who you ask—owner, buyer, or debt or equity professional. You need to know whether that value is tied to the income the self-storage facility is producing today, reflective of the past 12 months, or a projection into the next 12 months or more.

If the property has high occupancy and the market is improving, the seller will most likely want to project the income over the next 12 months. Alternatively, the buyer will want to review the profit-and-loss statements for the past year to determine what income was collected previously. These two value assessments can be quite different. When the market is slow, most investors tend to be conservative and focus on the trailing information. When the market is hot, like it is now, buyers need to look toward the future to stretch their pricing.

Rent and Other Revenue

Unit rentals are a huge part of self-storage revenue. When a buyer is assessing a potential acquisition, they need to figure out what they can reasonably charge for rental rates moving forward. Unfortunately, there’s no perfect answer. If you ask 15 people, you’ll get 15 different opinions. That said, this information is critical. If you’re off by just $1 per square foot, it results in a substantial shift in facility value.

For this reason, rental income is the first line item brokers discuss with self-storage owners, buyers, lenders and investors to determine overall value. It’s also the first assumption on which all parties must agree. Because the self-storage market has been aggressive, owners and investors are currently looking at what space will lease for 12 months from now, but it’s essential to determine what the market can truly support.

Don’t forget about ancillary income! When factoring revenue, you need to include all sources, not just the money from unit rentals and related fees. If a self-storage property offers any add-on products or services, they must be counted. These might include retail sales (locks, boxes, packing supplies), truck rentals, tenant insurance, boat/RV storage, wine storage or records storage. There could be a contract to host a cell tower on the property. It all must be included in the revenue side of the equation.

The Expense Side

Like income, self-storage expenses need to be assessed in terms of past, present and future. And again, there’s often a disconnect between buyers and sellers. For example, the seller may have only a part-time employee to handle facility landscaping, minor repairs and tenant requests. Their overhead is low. But the investor may prefer to have a full-time staff member in that position to more effectively manage the property. That adds extra payroll, taxes, etc., to projected costs.

Property taxes, which are one of the biggest expenses, can also be difficult to predict. Let’s say the seller purchased the facility 10 years ago at $2 million. Assuming there were no major building upgrades or additions, property taxes would increase only slightly during that period. However, once the asset trades for $5 million, the assessor’s office will flag it. This most certainly will result in a tax-bill increase, potentially doubling the cost moving forward and having a significantly negative effect on NOI.

Valuing a New Build

If a self-storage facility was recently constructed and hasn’t gone through lease-up, there’s no income or expense history to review; so, how do you determine NOI? To achieve the necessary estimates, you need to create a pro forma, which is a projection of all revenue and costs. There are several factors that can come into play here, but two of the most important are supply and demand. That means looking at market occupancy and competition.

In simple terms, if self-storage demand outweighs supply, rental rates and occupancies go up. If supply overshadows demand, they go down. Any potential investor needs to account for current and future market dynamics. They must do research to determine who’s already operating in the area and if there are any planned developments. If the market has a high population density and some new apartments under construction, it’s likely self-storage demand will increase, and the buyer should pay for projected revenue.

On the other hand, if there are other new self-storage facilities coming down the pipeline to increase competition, or population density is thinning, thereby decreasing the tenant pool, projected income might be lower. That would obviously lead to a lower valuation.

Unfortunately, future potential isn’t always apparent in a self-storage deal, and it’s easy for buyer and seller to disagree. The seller might look at the market and believe the property will lease up to 90% quickly. The buyer might see something in the projections that gives them pause, and they might forecast a lease-up of only 75% to 80%.

Risk Indicator

The cap rate should indicate the level of investment risk. The more a buyer can prove about a self-storage asset by way of income and expenses and the fewer assumptions they need to make, the lower the risk and cap rate. Conversely, the less they can prove and the more they must assume, the riskier the investment and the higher the return they should seek. More guesswork means more risk, which means a higher rate of return and cap rate.

If a self-storage facility has a great track record, performs well and is highly leased, the buyer doesn’t have to make a lot of assumptions. The level of risk and cap rate will be lower. If the facility is new, the buyer has to make several assumptions, including when it’s going to lease up, when rental rates will reach a certain level, and how much the property tax will be. If just one of those assumptions is off, it’ll result in lower—perhaps significantly lower—revenue. Therefore, the buyer will require a higher return to make the investment worthwhile.

Once everyone agrees upon the assumptions, it’s all just mathematics. I hope this explanation has helped you understand what a cap rate is and how it’s useful in determining investment risk and self-storage facility value. Happy buying and selling.

Steve Mellon is a managing director and leader of the national self-storage group for JLL Capital Markets, a global provider of capital solutions for real estate investors and occupiers. Specializing in self-storage acquisitions and dispositions, he’s been involved in $2 billion in property sales and structured financing/equity placement. He also consults with clients on ways to boost property value. Mellon has been a speaker at self-storage events and contributes articles to industry publications. To reach him, call 713.425.5835; email [email protected].