Capitalization rates are always the over-arching consideration for both buyers and sellers in the self-storage industry. Although the cap rate is a basic concept in real estate, many owners and prospective buyers do not clearly understand the importance of this ratio in property valuations.
Every new entrant into the self-storage facility market needs to understand the cap rate as a part of the essential math of income property ownership and sale. This overview is provided to help buyers and sellers of self-storage businesses gain clarity on the role of the cap rate in a property valuation.
What Are Cap Rates?
The capitalization rate (cap rate) is simply the ratio of an income property’s Net Operating Income (NOI) to the value of its property asset. For example, if a property has recently sold for $1,500,000 and its NOI was $120,000, then the cap rate is $120,000/$1,500,000, or 8%.
In the simplest terms, the cap rate reveals to an income property investor what percentage he/she can expect to earn if he buys the property with all cash. For example, if an investor thinks a property is worth a cap rate of 9%, he is expecting to obtain a 9% cash return.
How Does the Cap Rate Reflect the Business’s Value?
A high cap rate means a lower property value. Conversely, the lower your cap rate, the higher your income property’s value. Divide your net operating income (NOI) by the cap rate to calculate your property value. This reflects your income stream, which is an important consideration in determining a sale price for your self-storage facility.
Why Are Cap Rates Used to Determine a Business’s Value?
Real estate valuation involves a highly complex range of variables. Over the years professionals in the industry came to use the cap rate in a handy method of making quick calculations to determine comparative property values in a market.
Using the cap rate is just one of three different ways appraisers value properties. However, it is the method with which investors are most concerned. It’s a popular approach, because it has proven to be an efficient method of correlating a market’s property values. It’s also helpful in making comparisons between markets.
What Assumptions Must Be Applied in NOI Calculations?
The usefulness of cap rates in understanding comparable value of properties in a market requires that the NOI is calculated on a consistent basis for all properties. For example, operating expenses must be of a similar nature and standard.
Assumptions regarding expenses are not so universally applied as those regarding income issues. Sellers and other parties to income property sales processes can have important misunderstandings about these.
Here are some essential assumptions that must be made when calculating NOI:
Assumptions Regarding Income
- All revenues included in the calculation are from recurring operations of the property, such as rental revenues, vs. from an insurance reimbursement or from sale of the property.
- Debt service and depreciation have not been deducted from revenues in NOI calculations. These costs are capital and tax matters, not relevant to revenue generation.
Assumptions Regarding Expenses
- Property taxes have been adjusted to reflect the amount of the new valuation at the time of sale.
- There is appropriate insurance on the property.
- Advertising is being done in a professional manner.
- Expense numbers reflect market rates for labor cost of operating a self-storage facility. (If the owner is currently doing the work of an onsite manager without taking a salary, a salary amount should be included in the calculation.)
- Operating expenses are also assumed to include an off-site management company fee, in addition to expense for onsite management. Depending upon property size, the fee is typically assumed to range between 4% – 6% of gross revenues.
Some owners may reason that these basic assumptions don’t apply to their properties, due to certain exceptions that they believe should apply. However, in reality, there are virtually no exceptions in the real estate market. Ultimately, failing to employ these standard assumptions can seriously impact on the ability to sell or obtain financing for a self-storage property.
Why Do Cap Rates Vary Between Properties?
Because of differences between properties, cap rates vary. Today, typical cap rates fall within the range of 6.5% – 8%. The rate generally reflects the quality of the income property and the level of investment risk for a buyer. For examples:
- A small, rurally located facility built with inexpensive materials, and that has a high vacancy rate can be expected to have a cap rate reflecting a lower quality asset and higher degree of risk.
- A large facility of masonry construction, in a growing urban area, and that is continuously increasing unit rents can command a much more favorable cap rate.
Although cap rates vary, the fundamental assumptions regarding NOI do not. Admittedly, property valuations are, to some extent, subjective. However, industry professionals are well aware that experienced buyers and sellers do agree on NOI quality and on risk variances that exist within the narrow range of cap rates.
Do Cap Rates Truly Reflect the Self-Storage Facility Market?
Cap rates are so widely used in valuations because they are understood as accurately reflecting the marketplace. Nationwide, cap rate ranges do shift, as they have over the past decade. And, keep in mind that properties in small towns outside metropolitan boundaries are less likely to render cap rates in the same range as those in nearby densely populated cities.
Is it Better to Have a High or Low Cap Rate?
For Buyers — A high cap rate is most desirable for buyers/investors, because it indicates that the property value (purchase price) is low in contrast to the property’s actual income performance.
For Sellers — A low cap rate is more desirable for owners/sellers, because it indicates that the selling price/property value is high.
If the NOI of a property changes in subsequent years, the cap rate changes, therefore the value. The cap rate has an inverse relationship to value. Assuming the NOI remains the same, if the cap rate increases, the value decreases and vice versa.
For an Ideal Valuation Based on Cap Rate
The most essential decision to be made in the property buying and selling process is determining the value of the property. This overview of cap rates has covered the most basic information about how the rates are determined and how they affect valuations. It can help you get a general sense of the value of your self-storage property or potential investment in one.
However, being entirely objective in factoring income and expenses, and especially in comparing your property to others in your local market for purposes of determining the appropriate cap rate can be challenging.
Consult with a real estate expert whose focus is sale and purchase of self-storage facilities. There are various areas of specialized knowledge that require experts with the breadth of experience to provide fully informed analysis and advice.
For More Information
SkyView Advisors have completed more than $1.8 Billion of career transactions. SkyView is unique in the industry with its exclusive focus on self-storage purchase and sale. For more information about calculating cap rate or about obtaining a professional valuation of your self-storage property, contact SkyView to arrange a consultation.