“The market is cooling off.”
“Interest rates are going up.”
“Cap rates are going up.”
We hear all kinds of projections from experts about the self-storage market. The financial term most often used and least understood in these discussions is “capitalization rate,” most commonly referred to as a “cap rate.”
Investopedia defines cap rate as “the rate of return on an investment real estate based on the income the property is expected to generate.” That’s all well and good, but what does it mean in relation to self-storage, and how relevant is it to buyers and sellers in today’s market?
The Basics
Essentially, buyers and sellers use a cap rate to put a value on a self-storage property. If you were to ask an appraiser about cap rates, he would say that to determine the value of a piece of real estate, there are three methods: the comparable-sales approach, the income approach and the replacement approach. Depending on the property type, appraisers will place more weight on one of the three. For homes, the comparable-sales approach is more important. For cash-producing real estate, income is more important. In the case of self-storage, a market cap rate is used to determine property value based on net operating income (NOI).
When cap rates inch upward, it’s good news for buyers but not so much for sellers. Before we dig into why and apply a formula to calculate, here’s an easy way to remember what the figure represents: If you were to pay all cash for a self-storage facility, the cap rate is the rate of return on the income the property is expected to generate.
Figuring Value
To use a cap rate to determine value, you must first know the property’s NOI. This is critical. To determine the NOI, you simply subtract operating expenses from income.
Let’s say a self-storage facility has $1 million in annual income but $430,000 in annual operating expenses. Its NOI would be $570,000. When applying a cap rate, you’re really answering the question, “What will a ready, willing and able buyer pay for that $570,000 income stream?” Put another way: “How much can a buyer pay for that $570,000 and get the market return that income stream is generating?” Well, let’s figure it out.
If you don’t know the market cap rate, ask an appraiser. At the time this article was written, I consulted an appraiser who said the average cap rate for mom-and-pop-type storage facilities had been around 7.25 percent, but was moving toward 8 percent. He recommended using a market cap rate of 7.75 percent, unless a property needed a lot of deferred maintenance. To understand the significance of that half-percent increase in rate of return, let’s apply both cap rates to our example property to figure its value.
To calculate the amount a buyer can pay to achieve a 7.25 percent cash-on-cash return, divide the NOI by the cap rate. In this case, $570,000 divided by .0725 equals $7,862,069. In other words, if you paid $7,862,069 for a $570,000 cash flow, it would generate a 7.25 percent cash-on-cash return.
Now let’s look at the value of the same cash flow when the cap rate is increased by half a percent. (Incidentally, if you really want to impress someone with your grasp of cap rates, you can refer to this increase as “50 basis points.”) In this scenario, $570,000 divided by .0775 equals $7,354,839. Subtracting the second value from the first reveals that a half-percentage difference in the cap rate affects this facility’s value by $507,230.
Note: While this is the best way for small investors to use cap rates and can be used to determine facility value, it’s only optimal to calculate what one can reasonably pay for a facility if the NOI number is accurate.
|
|
Income |
Expenses |
NOI |
Cap Rate |
Value |
|
Scenario 1 |
$1,000,000 |
$430,000 |
$570,000 |
7.25% |
$7,862,069 |
|
Scenario 2 |
$1,000,000 |
$430,000 |
$570,000 |
7.75% |
$7,354,839 |
|
Difference in Value = $507,230 |
|||||
The NOI Factor
When I see an e-mail from a broker saying he just sold a property based on a 6 percent cap rate, my question is always: What NOI was used? Was it the actual NOI from the last calendar year, or the NOI from the trailing 12 months? Was it the NOI in the marketing package? Was it the NOI the buyer thinks can be achieved in year one? This makes a world of difference.
The real NOI is almost never the figure inserted in the marketing package. I believe the best way to determine NOI is to use the trailing 12 months of income and expenses. The “trailing 12” means using the last 12 months from whatever date you’re using to determine the value. For example, if you’re calculating value in October 2017, you’d look at October 2016 to September 2017. If that information isn’t available, the next best calculation can be derived from the last full calendar year, or in this example, January 2016 to December 2016.
The cap rate is an important factor in determining self-storage value. The better you understand its meaning and how it correlates to income and earning potential, the more you’ll be able to leverage it effectively to get the most out of your investment.
Buy smart. Buy strategically. But most of all, buy. The sooner you make an intelligent acquisition, the sooner that investment can begin working in your favor.
Mark Helm is a commercial real estate agent and self-storage investor. He began working with real estate investment trusts in the mid-1990s to locate and purchase self-storage properties before striking out on his own. He’s the author of “Creating Wealth Through Self-Storage” and the creator of “Storage World Analyzer,” a cloud-based, financial-analysis software tool designed to help self-storage operators and investors evaluate potential real estate acquisitions or development projects. To reach him, e-mail [email protected].
