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Understanding Cap Rates and How They Affect Self Storage

If you are a self storage owner looking to sell your property, or you are looking to purchase your first or next self storage property, your real estate broker will discuss values with you in terms of cap rates. Secondly, if you are a self storage owner and you are interested in refinancing your facility, your appraiser will determine a value using cap rates. So, what are cap rates and how do we determine what cap rate to use for your property? Why are cap rates used to begin with? And what is the current market using for the cap rate? Let’s review the answers and help you better understand cap rates.

What Is A Cap Rate?

Cap rate is short for capitalization rate. A cap rate is any rate used to convert income into value. It is a tool used in valuations of real estate to compare the ROI (return on investment) that may vary with rent rates, construction, location and a myriad of differences that can occur between two properties. Cap rates are also an indication for an investor to know what return he or she is looking for and what he or she is willing to pay when purchasing a self storage property.

How To Determine Cap Rates.

Cap rate is calculated by dividing the Net Operating Income (NOI) by the sale price.

CAP RATE   =  NOI  /  Sale Price
(expressed as a %)

So, to get your NOI, you will take the gross income generated by your self storage property, then subtract all normal operating expenses excluding depreciation and loan payments.

Then you divide this NOI by the sale price, and you arrive at the cap rate expressed as a percentage.

Gross Income  –  Normal Operating Expenses  =  NOI
(exclude depreciation & loan payments)

You can then also figure out a value by applying the appropriate cap rate to your NOI.

NOI  /  Cap Rate  =  Sale Price

expensesWhen calculating NOI, something to think about is that bankers and investors alike are going to insist that the expenses you use to determine NOI are what a normal operator would experience. This would include monies for repairs and maintenance, lawn care and snow removal (even if you do some or all of that yourself), management fees in addition to your property manager’s salary, and even a reserve fund for future capital expenditures.

Operating Expenses Include:
Property Taxes  •  Insurance  •  Payroll  •  Management Fees
Utilities  •  Advertising  •  Office Expense  •  Lawn Maintenance
Snow Removal  •  Repairs  •  Reserve Fund for Future  •  Capital Expenditures

Let’s look at an example. Say your facility has a gross income of $550,000. Your operating expenses are $175,000. Gross income less expenses equals a NOI of $375,000. Let’s say that your self storage broker says that self storage facilities of your size, condition and location are selling for 7.25% cap rates. To figure out the value of your property, we take the NOI divided by the cap rate of 7.25% (since cap rates are expressed as a fraction, you will divide by 0.0725). For example:

$550,000  –  $175,000  =  $375,000
(Gross Income – Operating Expenses = NOI)

If cap rates in your area are 7.25% = 0.0725

Then

$375,000  / 0.0725  =  $5,172,414

The value estimate equals $5,172,414

Now let’s say we are asking $5,175,000 for your self storage property. What cap rate would that sale price equal? Take your NOI and divide it by the sale price of $5,175,000 and you get a 7.25% cap rate. Remember, the lower the cap rate the higher the value. Conversely, the higher the cap rate the lower the value.

Lower Cap Rate = Higher Facility Value
Higher Cap Rate = Lower Facility Value

Let’s look at it this way. If an investor is paying all cash for a self storage property and he paid a 7.25% cap rate, he expects that he will make 7.25% on the money he invested in his first year of ownership. Keep in mind that most buyers do not pay all cash. They instead use bank loans to leverage their money, which increases their cash-on-cash returns to 9-11%.

Why Do We Use Cap Rates?

Now that you understand what a cap is and how they are used, let’s review the reason we use them in real estate.

Self storage properties are valued primarily on their ability to produce income. Cap rates take this income stream and assign it a value. This value, expressed as a cap rate, is based primarily upon the property’s ability to produce a stream of income in the future, and takes into consideration the perceived risk of maintaining that income stream.

Because cap rates consider only income, they can be used to compare other alternate investments such as other real estate besides self storage, stocks, bonds and businesses.

Remember that no two self storage properties are exactly alike. Self storage brokers and appraisers need a method to compare properties with different locations, physical conditions, quality of construction and level of management. Cap rates are adjusted up or down depending on the risk level of the property maintaining that future income stream.

Let’s take a look at two extreme examples.

The first one is a 15-year-old rural self storage property with no property manager on site. The risk factors you look at are the low population in that rural market, an abundance of land where a competitor may build a new property, and lastly what condition this property is in after 15 years of storage use. This property may be valued at an 8.5% cap rate.

The next extreme example is a property this is only three years old and located in a growing suburb. It was built with a large rental office and has a property manager on site full time. The value may be at a 6.5% cap rate because of the growing population, new construction, professional property management and barriers of entry for competitors.

property valueNow let’s look at what factors demand a higher cap rate and a lower value. Some examples are a self storage property with poor visibility from the road, no rental office on site or one that is not staffed with full time hours, deferred maintenance, low occupancy, little or no security features such as fences and cameras, declining population in the market, too many competitors, small overall square footage and poor facility design.

On the flipside, there are factors that will lower the cap rate and increase the property value. These include excellent visibility from the road and access from a major highway or artery serving the market, newer construction, professional property management with an on-site property manager and rental office, clean grounds, high occupancy, low delinquencies, security measures such as cameras, fencing, gates and door alarms, growing population in the area, square footage over 50,000 and a well-designed facility layout.

Although we have reviewed how to determine cap rates, it is in your best interest to have a professional self storage broker or appraiser with lots of self storage experience figure out the cap rate for your property. They should have at least five or six comparable properties with cap rates that you can compare.

With that being said, my experience in the mid-Atlantic states has shown cap rates range from a low of 5.5% for the best self storage properties to a high of 10% for self storage properties that are what you would call high risk investments. I have seen some self storage portfolios sell for less than 6% cap rates. The mean cap rate in the mid-Atlantic currently sits at 7.5%.

You have now learned what a cap rate is, you know how they are determined and understand why we use them in real estate. If you would like to learn more, our knowledgeable self storage brokers will gladly help. And, if you are ready to sell your self storage facility, our team can determine the proper cap rate and provide you with a free and confidential property valuation.


 

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