If you’re planning to sell or purchase a self-storage facility, your real estate broker will talk to you about value in terms of capitalization (cap) rates. If you’re an owner looking to refinance, your appraiser will also use a cap rate to determine value. As an owner, it’s important that you understand this metric! To help you get a firm grasp, let’s explore the ins and outs of the cap rate, including what it is, how it’s calculated and how it’s used in self-storage.

What Is a Cap Rate?

Per the third edition of the “Dictionary of Real Estate Appraisal,” a cap rate is “any rate used to convert income into value.” It’s a valuation tool used to compare return on investment for real estate assets, which may vary by rental rates, construction type, location and myriad other differences. The cap rate is also an indication of what return an investor is seeking and willing to pay for when acquiring a self-storage property. The lower the cap rate, the higher the value; the higher the cap rate, the lower the value.

How Is Cap Rate Calculated?

Cap rate is calculated by dividing a self-storage asset’s net operating income (NOI) by its sale price. To determine NOI, take the property’s gross income generated and subtract all normal operating expenses, excluding depreciation and loan payments. When you divide the NOI by the sale price, you’re left with a cap rate expressed as a percentage. Conversely, you can determine facility value by dividing the NOI by the cap rate.

Keep in mind that investors and bankers will insist that the expenses used to determine self-storage NOI are on par with what a normal facility operator would experience. They include repairs, maintenance, lawn care and snow removal, even though you may do some or all of these yourself. It also includes third-party management fees, staff payroll, and any reserve fund for future capital expenditures. Other operating expenses are advertising, insurance, office supplies, property taxes and utilities.

To understand how the cap rate works in action, let’s say your facility has a gross income of $550,000 and operating expenses are $175,000. The difference (your NOI) is $375,000. Your broker indicates that comparable self-storage facilities of similar size, condition and location are selling at a 6.5% cap rate. To figure out the proper sale price (value) of the asset, divide the NOI ($375,000) by the cap rate (.065), which is $5,769,231.

Now, let’s look at this in reverse. Let’s say we’ve sold your facility for $5.75 million. What’s the cap rate? Simply divide the NOI ($375,000) by the sale price ($5,750,000). That comes out to .065. Expressed as a percentage, it’s 6.5%.

Remember, the lower the cap rate, the higher the value; the higher the cap rate, the lower the value. If an investor pays all cash for a property at a 6.5% cap rate, he’s expecting that in the first year of ownership he’ll make 6.5% on the money invested. Of course, most buyers don’t pay all cash. They typically use bank loans and leverage their money, thus increasing cash-on-cash return to 9% to 11%.

Why Are Cap Rates Used?

Now that we’ve established the mechanics, here are few reasons why cap rates are used in self-storage transactions.

Potential income. Self-storage properties are valued primarily on their ability to produce a stream of future income as well as the perceived risk of maintaining that revenue. The cap rate takes this income and gives it a value.

Versatility. Because a cap rate is considered income-only, it can be used to compare other real estate types besides self-storage as well as alternate investments like stocks, bonds and businesses.

Comparables. Since no two self-storage properties are exactly alike, brokers and appraisers need a method to compare properties with different locations, physical conditions, quality of construction and level of management. Cap rates are adjusted up or down depending on the level of risk involved in maintaining a facility’s future income stream.

Let’s consider two extreme examples. For a 15-year-old facility in a rural area with no onsite manager, the risk factors include low population in the market area, the abundance of land on which a competitor may build, and the potentially poor condition of the property. This asset may be valued at an 8.5% cap rate. In contrast, a 3-year old property in a growing suburb, with a large office and showroom plus a full-time manager may be valued at a 5.25% cap rate. This site enjoys the benefit of a growing population of customers, new construction, professional management and barriers of entry for competitors.

Thus, factors that demand a higher cap rate (lower value) include:

Factors that lower the cap rate (increase value) are:

Who Sets the Cap Rate?

The cap rate for any self-storage property is best determined by a professional real estate broker or appraiser with plenty of experience in the industry. A qualified party should be able to show you a minimum of five to six similar properties, with cap rates, to demonstrate reasonable comparisons.

Depending on your area, cap rates can vary greatly. For example, in the mid-Atlantic states, cap rates range from a low of 5% for the best properties to 8.5% for sites that are considered higher-risk investments. Some well-valued portfolios have sold at a cap rate of less than 5%.

Whether you’re buying or selling a self-storage property, knowing how cap rates are determined and used will help you make smart investing decisions. I hope this article has improved your understanding of what they are and how they work.

Rick Hansberry is director of acquisitions for Investment Real Estate LLC (IRE), which brokers the sale of self-storage facilities in the Northeast and mid-Atlantic. He’s responsible for leading all legal and due-diligence efforts for the brokerage and acquisitions team. He also plays a leading role in strategic planning, accountability and setting company goals. For more information, call 717.779.0804; email [email protected].