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Understanding Cap Rates

"Capitalization rate,” or “cap rate,” is one of the most misunderstood terms in the self-storage business. I always feel a bit uncomfortable bringing up the subject of cap rates when discussing the sale of a property with its owner. I don’t know whether he understands the concept, and I don’t want to insult him by providing a definition that is too elementary. However, over the years, I have learned it’s best to assume the least. Following is a frank explanation of cap rates and how they work.

The most common misconception regarding the cap rate is it’s the number by which you multiply net operating income to arrive at property value. Many owners believe a “10 cap” means you multiply the income by 10. This is not the case. In fact, this misunderstanding results in a calculation that is actually the opposite of what a cap rate does. Using cap rates involves dividing, not multiplying. Lower cap rates mean higher values and vice versa.

Think of it this way: A property generates gross annual income of $200,000 and has annual operating expenses of $100,000. The net operating income (gross income minus operating expenses) is $100,000. This is the amount of cash flow generated by the property in the current year. This amount is fixed—it will not change. The buyer of the property will receive this amount for his investment. The accompanying chart shows how much a property that generates $100,000 of net operating income is worth at a variety of cap rates.

Self-storage properties are purchased for their cash flow. The more income a property generates, the higher its value. Buyers looking for an 8 percent return on their investment pay more for a fixed cash flow than those looking for a 10 percent return. As buyers often compete with each other to buy a given site, the buyer willing to accept the lowest return on investment will pay the most for the property. This type of buyer establishes the environment in which all purchasers must compete.

Factors exist outside of self-storage—and outside of real estate entirely—that affect cap rates. These factors consist of the availability of alternative investments and the risk/return available on them. These external factors are now in an alignment that has created the lowest cap rates in the history of our industry.

Bill Alter is a real estate broker. For 17 years, he has been a facility sales specialist with the firm of Rein & Grossoehme Commercial Real Estate in Phoenix. For more information, call 602.315.0771.

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