Benjamin Franklin once said, A penny saved is a penny earned. The same holds true in the real estate business, except we can expect an even greater return when trying to cut operating expenses.
At one time or another, weve all looked at our to-do list and thought, I can do that next month. Reviewing your operating expenses, however, is not something to postpone. Instead, look them over regularly to ensure your propertys value and cash flow are not being undermined by subtle, yet devastating, increases in operating expenses.
With capital flow of both equity and debt having dramatically increased over the past few years, and self-storage industry gaining respect from Wall Street, cap rates have been pushed to record lows. Along with historically low interest rates, this has led to values soaring for a number of self-storage facilities, making some owners complacent.
These higher values for storage properties are a result of the comparatively higher returns to other real estate asset classes and lower perceived risk. The lower operating cost and breakeven occupancy rates compared with other investments has led investors to think self-storage is less risky.
When values climb and cap rates compress, we must ask ourselves what happens when the market peaks. And how can we protect our investment? Its time for the self-storage industry to sharpen its ax and focus on what makes these facilities so valuable.
Net Operating Income
With the yields of some self storages REITs trading well below the U.S. Treasury, along with federal reserve concerns that inflation is getting out of control, understanding that the cap rate is no more than a rate of return on an investment leads me to believe that 90 percent or more of a facilitys value is in the net operating income (NOI) and cash flow. The risk owners face is not only whether NOI goes up or down, but that cap rates go up at a faster rate than NOI can compensate for the loss of value.
This is directly related to the interest rate a buyer or lender may be able to use when buying or financing a facility. With investors looking to maximize their rate of return and limit risk, its logical to think that if we control expenses and thus increase revenue, NOI and cash flow will increase asset value.
With 90 percent or more of the value being created by NOI, its important to understand what each NOI dollar means to the value of your facility. For example, lets take a self-storage property with annual revenue of $600,000 and annual expenses of $250,000. This facility will have an NOI of $350,000, which will then be capitalized at a rate of return acceptable to an investor to arrive at the value.
With cap rates being in the range of 7 percent to 9 percent, this facilitys value would be in the range of $3.8 million to $5 million. Reducing operating expenses by 8 percent, or $20,000 a year, would increase the value by $220,000 to $285,000. This means for every dollar added to NOI, youd receive $11 to $14 dollars in value.
The majority of self-storage expenses fall into three major categories: real estate taxes, management and advertising. Its understandable how yearly escalations in management and advertising contracts and property taxes can deteriorate the value.
Interestingly enough, you dont have to sell your facility to get an immediate gain from this capitalization of saved operating expenses; the value will be reflected in the amount you can borrow on the property. Generally speaking, thats 75 percent of the increase in value when you refinance. So, you can have your cake and eat it too!
| Base Scenario | 8% Decrease in Expenses | |
| Revenue | $600,000 | $600,000 |
| Operating Expenses | $250,000 | $230,000 |
| Net Operating Income | $350,000 | $370,000 |
| Value at 7% Cap Rate | $5,000,000 | $5,285,714 |
| Value at 9% Cap Rate | $3,888,888 | $4,111,111 |
In the world of real estate appraisal, this is considered the income approach. It takes into account the earning capacity of the facility less the vacancy and owners expenses. It is axiomatic that if NOI increases, the facilitys value dramatically increases. Thus, by reducing the annual expenses of your facility, you not only increase its value by a multiple of the market cap rate, you also increase how much you can borrow when refinancing, plus you benefit by the additional layer of protection from rising cap rates.
Understanding that every dollar of NOI has a multiplier factor caused by the current markets cap rate makes operating expenses a highly important component of the value. Historically, self-storages inelastic or stable nature of operating expenses and lower breakeven occupancy levels have left room for expenses to grow.
Due to compression in cap rates and higher prices being paid today, its increasingly important to make sure your expenses are in line. With the rising cost of utilities, taxes, insurance, advertising, labor and the threat of sales tax, review and management of operating expenses is inherent to the facilitys sustained value.
Other Options
Rethinking operating expenses and reviewing them regularly will keep your vendors and your expenses in line. For example, why fight the marketing battle with ancient technology when you can use high-tech lasers? As the Internet and other technological resources have taken market share away from the Yellow Pages and other media, you might want to consider using cost-effective online advertising.
Further, although tax time has come and gone, next year you should consider protesting your real estate taxes. The lower your real estate taxes, the more realistic a buyer or lender will be in evaluating the increase one might have when buying or lending on your facility. Contact your local tax authority about a protest process that is relatively easy to follow.
And lets not forget that it never hurts to get bids on your property insurance as the industry has seen large increases in property insurance premiums or the last few years. Remember that no box is too small to look for a dollar!
Self-storage is a high quality real estate investment class that has earned its way into the sector with higher returns and lower losses than the other four asset classes. But lets not forget what got the industry where it is today. Self-storage owners need to keep a close watch on expenses and continue to be active with local governments on issues such as sales tax and overbuilding.
Its safe to say that real estate values have been on the rise, and owners need to be diligent at reviewing and controlling their expenses if self-storage is to remain a desirable investment option in the real estate industry. The fact that owners get more cash flow and value as well is just a bonus of staying competitive.
