If you’re buying, selling or refinancing a self-storage property, it’s almost impossible to have a discussion without the term “cap rate” coming into the conversation. For many, this is an endless source of confusion. Everyone tends to act as if they know what they’re talking about, but while a few really do, many only think they know, and others don’t want to admit they don’t. Clearly, this isn’t a scenario meant to provide much mutual understanding.
This doesn’t have to be the case. Let’s take an in-depth look at cap rates to provide you a little insight and clarification on what they are and how they’re used.
What Are Cap Rates?
The term “cap rate” is an abbreviation for capitalization rate. Without the more confusing details, it’s simply the rate of return an unfinanced property would provide to an owner at a specific value. For example, if you had $200,000 of income from a property and wanted to earn an 8 percent return, you could pay $2.5 million for the property ($200,000 income divided by a .08 cap rate equals a price of $2.5 million).
The cap rate represents the relationship of value (price) to the income the property produces. Since value and cap rate are directly related, real estate folks like to talk about cap rates instead of value. By doing this, they can compare “values” of very different properties or property types. For example, if someone says one property with $100,000 of income and another property with $1 million of income are both an “8 cap,” he’s saying the income from each property would produce an 8 percent return on the respective price. In this case, the properties are being valued the same based on the relative income.
However, if one property was valued at a 10 percent cap rate and another at an 8 percent cap rate, the first property would be worth much less than the second because the purchase price would have to be lower to generate the higher return. Thus, if you know the cap rate and the income, you know the value, right? Well, now it gets tricky. Let’s start to refine our understanding a little more.
Defining Income
It’s important to note that the “income” used in the calculation isn’t what you put in the bank or report to the government. The first step is to not reduce income by depreciation or debt service (both interest and amortization). Also, deduct from expenses any “purely” personal expenses, but add a fair rate back into expenses for your time spent on the property. If your miscellaneous revenue (truck rentals, sales from locks, boxes, etc.) exceeds 10 percent of your gross revenue, get some advice because it may be treated differently.
These are just some of the adjustments that are made to income. The technical name given to this adjusted income is net operating income (NOI).
‘Stabilized’ Income
When you’re considering value (i.e., a sale, purchase or refinance), the income that produces the value must be “stabilized.” A couple of examples will demonstrate why this is important.
Let’s say the Olympics came to town and the contractors rented all of your units at twice your normal rate. That year would not be normal or “stabilized.” Alternatively, a year in which a fire destroyed half your units and it took six months to get them back in service also wouldn’t be stabilized. Neither scenario represents the characteristic income of the property.
A more typical situation in many markets today would be a facility that’s 93 percent occupied while other facilities in the same market have an average occupancy of 78 percent. What’s “stabilized” income in this case? It may depend on other factors, such as access, location, pricing or management. What should be clear is the notion of income stability introduces a large dose of subjectivity to the otherwise simple formula for determining value.
What’s the Right Cap Rate?
You’ve probably heard people talking about cap rates going down, or you may have heard someone say, “I sold on a 6 cap rate,” or “Cap rates are lower in California.” What does this all mean? Remember, cap rates are just another way of talking about prices in relation to income. The way the math works, lower cap rates mean higher values. So when someone says cap rates are down, he means prices (values) are up.
As we’ve learned, when a buyer purchases a property at a certain price, he’s also estimating the return he’ll get on the property on an unfinanced basis. He must be willing to accept that return. The return is the cap rate!
Let’s revisit some numbers: An 8 percent return on a $2.5 million (price) property is $200,000 (NOI) per year. The cap rate is an 8. If he only needs a 7 percent return, he could pay $2,857,000 for the property, and the cap rate would be 7 ($200,000 divided by .07 equals $2,857,000).
When we compare sales in a market, we find that similar properties tend to sell on similar cap rates. So when someone says a market is a “7 cap,” he means sellers and buyers are tending to agree on prices that yield the buyer 7 percent on the price. Some properties will be less desirable and may sell at a 9 cap (lower price), while others with a 100 percent, high-visibility location might sell at a 7 cap (higher price).
Self-Storage vs. Other Investments
The reason for all this agreement between buyers and sellers is they’re always looking at alternative investments and evaluating self-storage against them. If corporate bonds are yielding 10 percent, people will be more likely to invest in the bonds than self-storage facilities. However, if the bonds are returning just 3 percent, investors may decide the extra risk of self-storage makes a facility at a 7 percent return (cap rate) look good.
Thus, cap rates in general tend to rise and fall with the returns on competitive investments and interest rates. The “general” (some would call it “average”) cap rate is then adapted to the specific property based on a number of factors.
There are several facility characteristics that would lead to cap-rate adjustments in today’s general market. Some to consider are size, historical occupancy (last two years), competition within a three-mile radius, access, visibility, traffic count, household income within three miles, construction type, quality of accounting records, type of drive aisles, and local population growth, just to name a few. There may be arguments and different opinions on some of the specific characteristics and their relevance, but these can all have a meaningful effect on value.
The Cap-Rate Game
Cap rates were originally intended to be a useful tool to compare rates of return of properties and their values. However, in the real world, something very different is happening in the market. Many people are using cap rates for what I call “bragging rights.” Sellers, buyers and brokers are making up low or high cap rates so they can satisfy their own needs, ego or otherwise. They usually justify it by playing with income projections and expenses, if they bother to justify it at all.
Now that you know more about cap rates, make sure you’re dealing with a valuation prepared by someone with the professional exactness required to really understand value. Any other cap rate (too high or too low) is meant to serve only the purveyor’s interest and not yours.
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 and select a region. For more information, call 800.55.STORE; e-mail [email protected].