In my business, I spend a lot of time thinking and talking about the value of self-storage properties. My daily conversations are usually focused around interest rates, capitalization (cap) rates, new supply, time on market, loan-to-value ratio, basis points, net operating income (NOI) and a lot of other topics that rarely interest an owner, unless he decides to buy or sell a property. That’s because most owners are busy running their business and aren’t likely to sell anytime soon.

However, it’s helpful to understand the current real estate market, as it impacts your ability to run a successful operation. For example, you need to know what creates value in today’s market. Is it better to spend $10,000 on landscaping or $15,000 to add more 10-by-10 units? Here are some market factors and valuation methods that will help you make these decisions with confidence as well as some suggestions to improve facility value.

A Different Kind of Market

Before discussing valuation, you need to understand that the market is divided today. Many professionals feel things are slowing down, values are falling, mass overbuilding is on the horizon and the industry overrun. The rest feel we’re simply seeing a normalization. It’s true we’re past the all-time high in valuations for this real estate cycle and some markets are seeing overbuilding. However, overall, the market continues to perform well and above the returns of other real estate asset classes.

One clear difference in today’s market is the growth of mid-sized operators—those with more than 10 self-storage properties. These operators have grown from a just a handful a decade ago to more than 100-plus nationwide. They’re capitalizing on the economies of scale and strong market fundamentals the larger operators enjoy today.

The mid-sized operators are loving the immeasurable flow of capital into the self-storage sector, but also tend to overpay for assets and overbuild markets. This is because many are aiming to achieve the scale necessary to attract a real estate investment trust (REIT) as a buyer. With the REITs pulling back and exercising discipline, it’s left many of these groups with an unsure exit under current market conditions. However, they continue to grow and outbid many of self-storage household names.

Valuation Methods

Valuation is more an art than a science. While mechanical number manipulations are an important part of the process, there’s a large measure of real estate judgment and experience in developing a precise value range. True market valuation takes an in-depth look, noting not only value based on income but from a cost and sales-comparable basis.

The cost method compares the cost of replacing the facility in the market in which it’s located. The sales-comp method compares the value achieved in the marketplace with similar facilities in recent sales. Without reconciling the value from each of these methods, you can’t be sure you’ve identified the right property value. It’s a complicated process that requires the expertise of an active self-storage professional.

Over the years, real estate professionals and investors found they needed a shorthand method for comparing property values in a market, thus cap rates came into general use. Essentially, these tell you what you should expect to earn as a percentage if you purchased a property using all cash. For example, at a 7 percent cap rate, a property should yield an unleveraged 7 percent cash-on-cash return.

When the NOI is divided by the cap rate, you arrive at a property value. This method is essentially a way to develop a price based on an income stream. The net result is the lower the cap rate, the higher the value; and the higher the cap rate, the lower the value.

Let’s look at an example to illustrate the difference in valuation between two cap rates. Let’s say we have a typical self-storage property with an NOI of $250,000. Now let’s apply a 6.5 percent cap rate and an 8 percent cap rate, which is the range for most facilities in today’s market. To find the estimated value at these two rates, divide the NOI by .065 and .08. You get an approximate value range of $3,125,000 to $3,846,000.

Creating Value

We’re now past the point in the real estate cycle where we’re exclusively valuing properties on year-one projections or “pro forma.” It’s more important than ever to understand the local market and what’s creating value.

I’m seeing operators increase revenue by adjusting their unit mix to provide sizes that will rent at a higher value or greater velocity. Don’t be afraid to reduce your gross potential and convert units to sizes that are in greater demand. This will lead to higher revenue, more cash flow and an increase in value.

For example, if you have 150 vacant 4-by-5 units and no availability in your 5-by-10s, you’re missing potential profit. If you’re able to convert two 4-by-5 units into a single 4-by-10, you’ll rent it to the same customer who’s looking for a 5-by-10. The new unit size will help you gain a new customer—rather than turning him away—and create new revenue. It’s also worth noting that when you’re underwriting a property, you need to have a firm grasp on your operating expenses and ancillary sales.

Extracting Value

The selling process doesn’t create property value. The value is there all along, created by cash flow and market sentiment. Today, we’re experiencing a wide range of value due to the various views in the investment market and the large of amount of equity looking for a home in the self-storage sector. The range is 10 percent to 20 percent in some cases. Since most buyers and sellers are sophisticated and their lenders are ever more detailed, trying to find a “greater fool” who’ll pay a substantial premium isn’t only unproductive, it can have a serious negative impact on a property’s marketability.

The prices of self-storage assets are still within 10 percent of the peak of the market, and the uncertainties of our industry never less settled. If you’re at or near one of those “personal crossroads,” it’s time to think about your facility value and changes you can make to ensure you maximize its potential.

Ben Vestal is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self-storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. It also offers panel discussions in which brokers from around the country share their insights on self-storage market fundamentals and economic trends in their regions. To access recordings, visit www.argus-selfstorage.com/presentations.html. For more information, call 800.55.STORE; e-mail [email protected].