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Self-Storage Valuation Is Changing: Learn to Adjust Income and Expenses

Valuing a self-storage facility isn’t an exact science. While net operating income remains a key focus, owners also need to understand their current market and the nuances of what creates value, and then adjust their income and expenses accordingly.

If you own a self-storage facility, it’s important to understand the real estate market and the nuances that do and do not create operational success. Now more than ever, the value of industry assets is focused around net operating income (NOI) and whether that income is maximized and likely to go up or down in years to come. The old rule of thumb that 90 percent of your property’s value is in the NOI rings true today, particularly with all the new supply being delivered around the country and concerns about real estate taxes and other rising costs.

Today’s marketplace still consists of more buyers than sellers. The buyers vary widely and include institutional entities such as real estate investment trusts (REITs), private-equity funds, large self-storage operators, high net-worth investors, exchange buyers and new investors from other real estate sectors. The excess of buyers and the fluid debt market have continued to fuel the industry boom and strong transaction velocity. However, valuation is softening due to buyers’ unwillingness to project future NOI growth.

It appears it’s time to adjust course, as we’re seeing meaningful headwinds on the horizon for self-storage operators. This is clear in the chart below, which outlines NOI growth for the five industry REITs over the last 16 quarters. As you can see, they’ve seen downward pressure for 11 consecutive quarters and operating performance continues to deteriorate.

Vestal-REIT-NOI-Growth-2019.JPG

Navigating a market with decelerating NOI is tricky. Buyers are looking for a reasonable return on investment, but how they view that return may vary from person to person. When underwriting a property’s operating performance, existing owners have the advantage of market knowledge, particularly if they’re already managing properties in the market. A new buyer must rely on existing operating reports, income statements, market studies and investment advisors to form an educated opinion of potential value. Let’s look at some typical income and expense adjustments to consider when valuing a self-storage property today.

Income Adjustments

Income adjustments vary widely form deal to deal and can be sorted into multiple categories:

Rents. In markets experiencing new supply, many owners are slow to adjust pricing to reflect local rents. Existing customers are being replaced with new ones at a slower pace and at a lower rental rate. You must adjust the property’s gross potential income to reflect current market rents, not what the owner is charging.

Concessions. Typically given in the form of free rent, concessions can vary widely depending on location and season. I’ve seen 8 percent to 12 percent concessions, which equals one to one and a half months of rent. However, you must look at the average length of stay to truly understand the impact of the discount. If new customers are staying for less than a year, it’s easy to see how concessions can balloon to 16 percent to 24 percent.

Tenant insurance. The large self-storage operators have all adopted tenant insurance as the industry standard and push it aggressively to customers. The profit margins can be as high as 90 percent, with penetration at more than 70 percent. Smaller operators should also consider offering this product, expecting a margin closer to 25 percent to 50 percent and penetration of around 30 percent to 50 percent.

Ancillary income. This includes late and administrative fees, product sales, and truck-rental income. I typically see ancillary income at 2 percent to 5 percent of total revenue. Late fees in particular can add up for operators who are aggressively enforcing company policy. However, each property is unique and should be evaluated on a case-by-case basis.

Expense Adjustments

Expenses adjustments can also vary widely and be organized into several categories. You must review each. Below are some on which to focus:

Real estate taxes. In most cases, these are one of the single largest and fastest growing self-storage expenses. Every state has its own property-tax nuances. For example, in California, it’s pretty straightforward with Proposition 13, which sets the real estate tax at the point of sale at around 1 percent to 1.3 percent of the sale price. In non-disclosure states like New Mexico and Texas, it’s more of a guessing game.

When buying or selling self-storage, you must adjust the real estate taxes to reflect a new valuation after sale. Check with your broker if you have questions about property-tax treatment in your state.

Payroll. This can fluctuate widely and may be adjusted by as much as 20 percent to 30 percent. Many owners have employees who’ve been with them for many years. Adjusting payrolls may be a sensitive area because most want to treat their employees fairly and protect their positions upon sale. With the United States at nearly full employment, we’ve seen payroll cost rise meaningfully over the last few years.

Personal expenses. Many self-storage owners run personal expenses through their facility’s operating statement. These typically include travel, dues and subscriptions, vehicles expenses such as gas, and more. Identifying these upfront and extracting them from the profit-and-loss statements will help in preparing the financial statements and optimizing the property’s market value.

Third-party management fees. With a real estate investment, buyers will be looking to include a third-party management fee of 4 percent to 6 percent of gross revenue as part of the operating expenses. Owner-operated properties might not always include this on their financial statements; however, you must include a third-party management fee to arrive at a realistic NOI. Real estate investors aren’t looking for a job and will be required by their lender to include this fee in their underwriting.

There’s one exception to this rule and that’s rural properties that are less than $1 million in value. A third-party management fee isn’t required in the underwriting and valuation of these smaller facilities; however, you must include adequate payroll.

Of course, every valuation and transaction is unique and requires an understanding of many facets, including management, occupancies and market, to name a few. Additional adjustments to value can include necessary capital improvements, capital reserves, market-specific expenses and facility upgrades. Based on the adjustments discussed above, you can understand how valuation is changing. As you evaluate your self-storage asset, be realistic on your investment horizon, as you must decide what to do to maximize your return.

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 buyers and sellers via an extensive marketing platform for self-storage properties. Property listings and informational resources can be found at www.argus-selfstorage.com. For more information, call 800.55.STORE; e-mail bvestal@argus-realestate.com.

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