We’re here to talk about capitalization rates, also known as cap rates. This metric is used by real estate investors to help quantify asset value, but it tends to cause confusion. For that reason, some people say it’s overrated; but I think it’s worth the hype. Let’s look at what it is and why it makes sense to use it.
At the most basic level, a cap rate is a number, expressed as a percentage, that depicts the anticipated annual return on investment (ROI) for an asset such as a self-storage facility. It’s calculated by dividing net operating income (NOI) by the property’s market value or asking price. For example, a facility with NOI of $50,000 and an asking price of $1 million would have a cap rate of 5%. Ultimately, cap rates help property stakeholders predict value, maximize ROI and, ideally, mitigate investment risk.
The important thing to understand about the relationship between cap rate and value is that it’s inverse. The higher the cap rate, the lower the value/price. On the other hand, the relationship between cap rate and potential return/risk is direct. That is, the higher the rate, the higher the return/risk. If an asset has a low price (high cap rate), it may be due to low NOI. That can also be why the potential return (or risk) is higher.
Why Use Cap Rates?
In commercial real estate, investors now quickly ask about an asset’s cap rate when trying to assess its value. In fact, cap rates serve a key role in the initial assessment of a property. Sellers want to know the cap rate investors are willing to accept, and investors want to find a cap rate that satisfies the seller but is still profitable.
Cap rates allow self-storage owners (sellers) and investors (buyers) to compare similar properties within the “same market,” but be aware that defining that market can be a stumbling point. Really, a submarket should be identified. This is a smaller market within a larger Metropolitan Statistical Area (MSA). For example, consider the Atlanta MSA. A self-storage facility just north of Atlanta in Sandy Springs, Georgia, shouldn’t be compared to one southwest of the city in Newnan, Georgia.
To complicate matters, investors need to further review the surrounding property values, leasing rates, risk factors, new developments and rental rates. It’s good practice to take a top-down approach by first focusing on trends within the larger MSA, then examining performance in the specific submarket.
In addition, investigating comparable properties that have closed within the past year, including purchase price per square foot, can provide a clearer picture of what the cap rate should be for a property. Other potential considerations include individual characteristics of the target property (access, location, features, etc.), new builds entering the market, and variations in rental rates.
Though there can be variations in opinion, cap rates allow owners and investors to identify potential loss/gain for a site. When considering an acquisition, experienced investors use them in combination with intimate knowledge of the submarket and future value.
Different Types of Cap Rates?
Yes, to make matters more complex, there are different types of cap rates. For example, most short-term investors will calculate the going-in cap rate for a potential acquisition, which is simply NOI from the prior year divided by the purchase price. This is often the only rate they’re interested in because they don’t intend to hold the property long-term.
Conversely, long-term investors need to concern themselves with the terminal cap rate, also referred to as the exit rate. This is used to value the property through the end of the holding period, or the time the investor plans to own the property. This calculation considers variations in the NOI over time.
To reach a terminal cap rate, a dynamic spreadsheet is used to calculate future value (FV) from present value (PV) over the course of the investor’s holding period using a simple or complex interest rate. When using a simple interest rate, FV is calculated using the formula FV = PV (1 + rt), in which the “r” represents the rate of interest per annum and “t” represents the time in years. Savvy investors opt to use a compound interest rate, however, as the results are more meaningful. That formula is FV = PV (1+i)t, in which “i” represents rate of interest.
Worth the Hype or Overrated?
Based on the above, I hope you agree cap rates are worth the hype. They provide self-storage owners and investors with a comparable asset-value metric based on a fundamental equation both parties can understand.
Just keep in mind that a cap rate will never fully represent the potential value of a specific property. Only the investor themself can determine this based on the level of risk they’re willing to assume, how long they plan to hold the property, and the performance of comparable asset-class properties in the submarket. They should also calculate future value to ensure a profitable ROI at the end of the holding period.
Melissa Shandor serves as strategic advisor in California and the Pacific Northwest for The Storage Acquisition Group, which specializes in acquiring off-market self-storage facilities and portfolios nationwide. The company also offers market-analysis reports, underwriting and closing support. Melissa uses her background and expertise in data analytics to acquire assets and maximize return on investment for sellers. To reach her, call 704.202.4350; email [email protected].