In the business of buying and selling self-storage properties, the discussion always ends with capitalization (cap) rates. Unfortunately, most people don’t fully understand all of the ramifications of this simple-sounding number. We have many new investors in the marketplace who’ve never purchased a storage property and are just learning the basics with regard to underwriting. Hopefully, this summary will help clarify the fundamental concept.
What Are Cap Rates and Why Use Them?
Real estate valuation is a very complex business, with many variables that affect price. Over the years, real estate professionals found they needed a way to compare property values in a market using a shorthand method, thus cap rates came into general use.
Essentially, a cap rate tells an investor what he should expect to earn as a percentage if he purchased a property using all cash. For example, if he thinks a property is worth a 7 percent cap rate, then he expects to receive an unleveraged 7 percent cash-on-cash return. However, we all know that operating expenses vary from one facility to the next.
Often these variances lead to a deal having three different cap rates: the one the seller is using, the one the buyer is using and the one the broker is representing. These rates are typically pretty close, but with the reassessment of real estate taxes and the increased operating expenses being faced by many institutional operators, a cap rate quote can be misleading.
When the net operating income (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 income stream. The lower the cap rate, the higher the value; the higher the cap rate, the lower the value. This is only one of the three methods used by appraisers to value a property, but it’s the one most focused on by investors. It’s primarily used because it does a good job correlating property values and helps facilitate comparison between markets.
Underlying Assumptions in Calculating NOI
As with any good rule of thumb, there are certain assumptions that are implicit in the calculation of NOI. For cap rates to be useful and comparable, the NOI must be calculated on a consistent basis on all properties. For example, the operating expenses must be similar in nature and somewhat standardized to compare “apples to apples.”
The first assumption when calculating the NOI is all revenue must result from reoccurring operation of the property (rental revenue), not from an asset sale or insurance recovery. Second, depreciation and debt service shouldn’t be deducted from revenue to arrive at the NOI. Depreciation and financing costs don’t reflect value, but merely tax issues and capital structure. These revenue assumptions are clearly defined and almost universally applied.
However, assumptions related to expenses are less uniformly applied and result in significant misunderstanding, particularly among sellers. They should include that the property is properly insured and advertised in a professional way. Property taxes should be adjusted to reflect what the new valuation will be at the time of sale.
Further, the expense numbers need to reflect the market-labor cost of running a self-storage property, which should include an onsite manager’s salary if the owner is currently doing the work for free. It’s also assumed that the operating expenses include an offsite management fee over and above the onsite management expense. This will range from 4 percent to 6 percent of gross revenue depending on the size of the property.
Many owners will say some of the assumptions don’t apply to them for various reasons, but I can assure you there are almost no exceptions in the marketplace of real sales. In the end, ignoring these assumptions is at best self-deception and, at worst, can have serious impact on the financing or sale of a property.
The Case of Higher or Lower Rates
Since not all properties are alike, they command different cap rates. The variations from normal cap rates (between 5 percent and 8 percent today) usually reflect the quality of the project and risk to the investor. For example, a 40 percent vacant metal-building project in a rural area would require a higher cap rate to reflect the increased risk and lesser quality asset. On the other hand, a large masonry project with full security in a growing metropolitan area with consistently increasing rents would command a premium cap rate, perhaps in the range of 5 percent to 6 percent.
Again, while the cap rate may vary, the underlying assumptions about the NOI don’t. Property valuations are somewhat subjective, but our collective experience would indicate that knowledgeable buyers and sellers agree on the quality of the NOI and with the risk variances that lie in the narrow range of cap rates.
Do Cap Rates Really Reflect the Market?
The answer is unequivocally yes! If cap rates didn’t reflect the marketplace accurately, we wouldn’t be using them in so many ways. The accompanying chart gives you an idea of how cap rates have varied over the last 10 years. Please keep in mind this takes into consideration all self-storage properties around the country. Remember that a property in a small city or town won’t command the same low cap rate as one in San Francisco or Midtown Manhattan.
As you can see, the market has seen a constant decline in cap rates for self-storage properties over the last several years, from an average of 10 percent in 2000 to 5.75 percent in 2015. This is largely due to the increased industry data now available that indicates the overall risk associated with owning self-storage properties is much less than once thought. Not to mention we’ve had a great run of low interest rates for the past decade, which has also fueled the increase in value of almost all income-producing real estate, including self-storage.
However, the most intriguing metric in the chart is the spread between cap rates and interest rates, indicated by the red line. As you’ll notice, the trend is less constant than the more consistent cap-rate and interest-rate trends. The narrowing of the spreads between cap and interest rates today would indicate the market is realizing once again that the stability of self-storage income streams is very durable.
The above review of cap rates covers the basics of how they work and their effect on valuation. They should allow you to arrive at a ballpark value for your new investment or current self-storage property. However, you must be impartial when making the judgment call required regarding income and expenses, and compare your project to other comparable sales in your market to arrive at an appropriate cap rate.
Understanding and setting the value of a property is the single most important step in the investment process. If you’re thinking about getting expert advice when evaluating an asset, it’s important to consult with a real estate professional who specializes in self-storage. There are some things unique to self-storage with which an average broker may be unfamiliar, regardless of his other experience or intentions.
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].