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The Cap Rate and Self-Storage Asset Value: An Overview of This Key But Complex Metric
When it comes to determining self-storage facility value, most buyers and sellers turn first to capitalization (cap) rates. This number can provide insight to an asset’s anticipated annual return on investment; but it can also be confusing, as there are many factors involved. This article provides a quick explanation of how cap rates are determined and applied.
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When an investor is looking to acquire a self-storage asset, one of the first metrics they typically consider is the capitalization (cap) rate, which is derived through a simple calculation. You take the facility’s net operating income (NOI)—excluding debt costs, interest payments, depreciation, amortization or income taxes—and divide it by the asking price. The resulting number is the cap rate, expressed as a percentage. For example, if the NOI is $120,000, and the asking price is $2 million, the cap rate is 6%.
The cap rate represents the return the self-storage investor could expect over a one-year period. Sometimes, it’s the expected first-year income. In other cases, it’s the trailing 12-month NOI.
The cap rate can also work in reverse to help an investor determine how much they should reasonably pay for a self-storage asset. For example, if they know that other facilities in the area have recently traded at a 5.5% cap rate, they could calculate a price using the NOI:
NOI / cap rate = current market value
$120,000 / 5.5% = $2,181,818
It’s important to note that as the cap rate goes down, the asset value increases. In other words, a lower cap rates equals higher value.
The Challenge of Getting to the Right NOI
This all sounds pretty simple, right? You just need to know a few key numbers. The issue in the self-storage industry is arriving at the correct NOI, which is gross income minus expenses. These amounts aren’t always clear-cut.
For example, there’s no way to know what revenue for a self-storage asset will be for the next 12-month period. With the short-term nature of our leases and the dynamic pricing models in use today, monthly rents can fluctuate significantly. For that reason, most buyers look at the most recent 12 months as the easiest way to estimate gross income; however, in most cases, this leaves money on the table. Why? Because it doesn’t take into account potential improvements in income such as rent increases, customer fees, or ancillary products and services, all of which might be added to the revenue stream in days to come.
On the expense side, the math can get even fuzzier. As I mentioned above, there are certain expenses that are never factored into the NOI calculation. These include debt service (loan payments and interest), capital expenditures, depreciation and income tax. Among the expenses that do count, some can fluctuate wildly, like property taxes and insurance. Costs for staff payroll and advertising can also go up or down based on various market factors.
If the self-storage property is professionally managed by a third party, you generally back out the cost of that service from the expenses, as the new owner may not wish to continue it. Similarly, you may need to make other adjustments. For example, if the owner charges the business for personal expenses such as car payments or their cell-phone bill, those should be backed out of the calculation. The same is true if they’re taking payroll distributions, as the new owner may not do so.
Below is an example of how expenses affect self-storage value when applying a cap rate. In the first column, expenses are estimated at only 25% of gross income, which is below market. The second column shows those expenses after as-typical adjustments. They’re now up to 38%. A seller may be hoping for a $10 million sale, but $8.3 million may be more realistic, depending on the cap rate for that market. If the new owner is able to improve revenue through aggressive in-place rate increases, ancillary sales, and higher customer fees, they can improve their first-year return; though the cap rate is still higher (lower value).
The difference between what a self-storage owner wants for their facility (in this case $10 million) and what they can realistically achieve based on the NOI ($8.3 million) is referred to as the bid-ask spread. The frequent discrepancy is the reason real estate transactions are down. To achieve a stable, normalized market, we’ll need to see some seller capitulation.
While cap rates are a common way to determine self-storage value, they aren’t the only metric that should be used. As an investor, you must consider your level of risk, the overall market, the upside potential for the property and other factors. Taking all these into account, along with the cap rate, can help you determine a potential acquisition’s true worth.
Tom de Jong is executive vice president for Colliers International and a founding member of the company’s de Jong | Becher Self Storage Team, which has more than 30 years of combined industry experience and more than $1 billion in closed transactions. To reach Tom, call 408.282.3829 or email [email protected].
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