You may be wondering how to put a value on your self-storage facility and if recent events in the financial markets have affected what your property is worth. Perhaps you’re considering selling or refinancing, or simply want to know the value for estate-planning purposes. Regardless of the reason, the methodology of determining your property’s value is the same.
The first concept to understand is value is based on cash flow, not on how much you paid for the property, how long you’ve owned it or how much it cost to build. Hopefully, your property is worth more today than it was when you bought or built it, but time alone doesn’t cause income property to appreciate. There are only two factors that affect property value: net operating income (NOI) and the capitalization rate (cap rate). NOI is calculated the same way now as it has always been, but recent turmoil in the financial markets and economy have pushed cap rates higher.
NOI is the money left after all operating expenses are paid, excluding debt service and depreciation. The accompanying charts show a typical self-storage facility’s unit mix and rents. You can see that monthly potential rent flows into annual potential rent, to which is added other income and from which is subtracted economic vacancy. The resulting figure is effective gross income (EGI). Operating expenses are subtracted from EGI resulting in NOI.
It’s important that NOI be calculated for all self-storage facilities using industry-standard parameters for other income and operating expenses. The hypothetical example displayed in the charts uses those industry standards.
Income is an easy figure for an owner to determine and a lender or buyer to verify. There’s seldom a difference of opinion regarding income―it’s simply the amount of money deposited in the bank. One must assume an owner is doing all he can to maximize income. This means rents are as high as possible and in line with competition. It also means the facility is managed, advertised and marketed adequately and occupancy is as high as it can be given the market.
It’s important to note that incomes from properties of the same size and in the same market area, may not be the same. This is because income is limited by the average unit size of a particular facility. Two properties of the same square footage, occupancy and rents may have different unit mixes. These two properties would generate different incomes and have different values.
Everything else being equal, a 90 percent occupied, 50,000-square-foot property with 600 units and an average unit size of 83.33 square feet will be worth more than a 90 percent occupied, 50,000-square-foot property with 500 units with an average unit size of 100 square feet. This is because smaller units generate higher rent per foot and correspondingly higher sales prices per square foot at the same cap rate. Sales comparables report price per square foot but not average unit size. As a result, it could be incorrect to estimate property value by simply using the price per foot of recent sales.
Understanding Operating Expenses
The other component of NOI is operating expenses. Unlike income, there can be a difference of opinion regarding expenses. You may employ a professional management company or have a maintenance reserve account. You may pay salaries for full- or part-time employees or have inadequate insurance coverage. Real estate taxes may increase substantially when a property sells. Buyers estimate that increase, but it’s irrelevant to you unless you’re selling.
For the reasons cited above, the potential exists for different NOI calculations on the same property. This is why industry standards are used to confirm expenses are in line.
Cap Rates Fluctuate
After a property’s NOI is calculated, the appropriate cap rate must be applied. Several factors are considered when selecting a cap rate, which can be adjusted lower or higher depending on the age and quality of the property and market characteristics. A larger, newer property constructed of masonry with a longer remaining economic life, state-of-the-art security system and in a growing area would command a better (lower) cap rate than an older, metal property in a market that’s not growing.
This article was written at a time of great uncertainty in real estate lending. Lenders have tightened their parameters or withdrawn from the market entirely. This makes financing difficult and more expensive to obtain. The cost of financing is material to property value because, ultimately, the reason properties are bought is for their after-debt-service cash flow. Higher financing costs push cap rates up to maintain acceptable cash flow. The accompanying charts use the NOI from a hypothetical property to show how a 200 basis point increase in rate can affect value by almost $2 million.
The real estate market has changed dramatically in the past two years, affecting the value of all property types, not just self-storage. Owners must be aware of these changes and their impact on value if they are going to actually going to accomplish what they set out to do.
Bill Alter, a real estate broker, has been a self-storage sales specialist for 24 years with the firm Rein & Grossoehme Commercial Real Estate in Phoenix. To reach him, call 602.315.0771.