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While You Were Napping

July 1, 2005

4 Min Read
While You Were Napping

You didnt have to raise rents, lower expenses or even increase your occupancyyet you made a lot of money over the last three years or so. In fact, it may have been so easy you didnt know it happened. While you were busy tending to other things, the real estate market became incredibly hot, and interest rates hit lows not before seen in your business lifetime.

A Typical Facility

 

Class

A

Size

40,000 SF

Occupancy

88%

Rent

$8.52/SF

Expenses

33%

Loan to Value

75%

NOI

$200,000

Let your eye be drawn to Table 1, which represents what has happened to a typical storage facility over the last few years. Being very clever, you will note the increase in value and equity this happy circumstance created. Of course, the equity is the number that interests you most, as it represents the net value of your ownership. Notice a whopping 71 percent increase. Its especially nice because you didnt have to do anything different to earn it.

Table 1

 

2001

2004

Percent Increase

Cap Rate

10.0

8.5

 

Value

$2,000,000

$2,353,000

17.7%

Loan

$1,500,000

$1,500,000

 

Equity

$800,000

$853,000

70.6%

NOI

$200,000

$200,000

 

Debt Service (25 Years)

$144,000 @ 8.5%

$110,000 @ 5.5%

 

Cash Flow

$56,000

$90,000

60.7%

Why Did It Happen?

Why did this extraordinary increase in value and equity occur? The really short story is interest rates went down, and real estate investors were willing to pay more for property that would reap better returns than they could get at the bank, in stocks or in bonds. The cap rate generally represents the total return an investor is willing to accept when he buys a real estate asset. When cap rates drop, prices go up. Its just simple math. (For more details on how cap rates work, read Cap RatesA Mystery Unveiled, in the November 2004 issue of Inside Self-Storage.) It has also helped that, for the first time, self-storage was considered a full-fledged, certified real estate product by major buyers and lenders.

What If You Refinanced?

The good news never seems to end. Not only were things even better if you refinanced, you had a very pleasant choice to make. First, if you didnt want to increase your loan amount, your cash flow would have gone up 61 percent (as you can see from our example). That is sure easier than raising rents. However, if you maximized the loan, you could have taken out $265,000 in casha little more than half of your original equityand still increased your cash flow by $2,000. Oh, the wonders of financial leverage!

So Whats the Bad News?

Interest rates have started to climb, and Mr. Greenspan seems committed to continuing their upward movement while his hand is on the lever. At the moment, there are still many eager buyers around. But as interest rates rise, they simply wont be able to pay as much for the same dollar of income, and facility prices will fall. There are also persistent rumors about overbuilding, though theres probably quite a bit of truth to them. In the long run (maybe not so long), the law of gravity still applies: What goes up must come down. The bad news is the mathematical phenomenon that helped increase values works the same wayand in the same magnitudein reverse.

What Can You Do?

If you plan to keep your facility forever, refinance now. If you arent absolutely sure you want keep it for at least five more years, consider selling. If your facility is not state-of-the-art or in a very good location, you have competition coming on board, your rates and occupancy are not increasing, or you have personal issues that might require you to let go of your business, now is the time to get serious about selling. Dont let your valuation go into reverse. Remember, you had no control when it went up, and you wont have any control when it goes down. Dont be caught napping.

Michael L. McCune has been actively involved in commercial real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real estate consulting, brokerage and development company based in Denver. In 1994, he created the Argus Self Storage Real Estate Network, now the nations largest network of independent commercial real estate brokers dedicated to buying and selling self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.

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