“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 industry today. However, nothing probably the most often used and least understood financial term is “CAP Rate.”
What does it really mean and how is it relevant to a buyer or seller in self storage today?
Well, first a few basics on what a “CAP Rate”, or Capitalization Rate is.
The definition of a Capitalization Rate is “…the rate of return on an investment real estate based on the income the property is expected to generate” (Investopedia”).
Ok, we did that. Now let’s look at what it really means and how we use it everyday in our business.
We use it as buyers, sellers, and owners of self storage to put a value on a self storage facility.
If you were to ask an appraiser about CAP Rates, they would say something like this.
“To determine the value of a piece of real estate there are three methods:”
- Comparable Sold Approach.
- Income Approach.
- Replacement Approach.
Depending on the type of real estate, we put more weight on one of these three approaches. For homes, the comparable sold approach is more important. For income producing real estate, the Income Approach is more important.
In the Income Approach, we use a “market” capitalization rate (i.e. CAP Rate) to determine, the value of the property based on the Net Operating Income cash flow.
Today, as CAP rates start inching upward, that is good news for buyers and not as good news for sellers of self storage.
Why?
Well, lets take a look. But before I give you the formula, let me give you an easy way to relate to CAP rates.
If you were to pay all cash for a self storage facility, what would your rate of return be?
It would be what everyone calls a “CAP Rate”.
Let’s look.
Here is a self storage facility’s income numbers. To use a CAP rate to determine value, one has to first get the the NOI (net operating income). That is a critical number. Here is the simple formula.
Income – Operating Expenses = Net operating Income (NOI)
Let’s say your facility’s numbers are, or the factious facility you are considering purchasing number’s are the following:
$1,000,000 – $430,000 = $570,000
One million dollars of income less the four hundred and thirty thousand dollars of operating expenses, equals five hundred and seventy thousand net operating income (NOI).
So to determine the value of the facility using a CAP Rate, you are really answering the question, “What will a ready, willing and able buyer pay for the $570,000 income stream?”
Said another way, how much can a buyer pay for the $570,000 and get the “market” return that income stream is generating?
Well les figure it out.
If you don’t know the market rate, ask an appraiser. That is just what I did before writing this article. He said the average had been around 7.25% for mom & pop type facilities, but it looks like it is moving towards 8%. He said I would use 7.75% today unless there is a lot of deferred maintenance that is needed.
So remember, that means if you were to pay all cash for the above facility, a little while ago you would have paid an amount that generates a 7.25% return.
To calculate the amount, you can pay to get a 7.25% cash-on-cash return, you take the NOI and divide it by the CAP Rate:
$570,000 divided by .0725 = $7,862,069
So in other words, if you paid $7,862,069 for a $570,000 cash flow, that would generate a 7.25% cash-on-cash return.
Now let’s take a look at the value of the same cash flow, when the CAP Rate has increased .50% or, if you want to really impress someone say “fifty basis points”. The equation would be:
$570,000 divided by .0775 = $7,354,839
So there you go, a half a percent difference in the CAP Rate effects this facility’s value by $507,230 ($7,862,069 – $7,354,839 = $507,230).
This is the best way for the smaller investors to use CAP rates.
But remember, this is just one way for you to determine the value of a facility you are looking at. I personally don’t think it is the best way for the smaller investor to determine what they can pay for a facility, but it is one way to put a value on a facility.
So when I see an email from a Broker saying “Just sold on a 6% Cap Rate”, I have a question for them. “What was the NOI used to determine that CAP Rate?” Was it the actual NOI from last year? The trailing 12 months? Was it the NOI in your marketing package? Was it the NOI the Buyer thinks it will be in year one?
That would make a big difference wouldn’t it?
I really spend most of my time when I am using a CAP Rate (income approach) to determine value on a facility, getting to the real NOI. It is almost never what is in the marketing package. The best way to determine the real net operating income in my opinion, is to use the “trailing 12” months income and expenses to generate it. That is the last twelve months from whenever you are determining the value.
The next best way, in my opinion, is to use the last calendar year’s income and expenses to get to the real net operating income.
Using a CAP Rate is a valuation method used by many of us every day to determine the value of a self storage facility. Hopefully, now you have a better understanding and relationship to this method and can use it more effectively to get in this fantastic business of self storage.
Buy smart, buy strategically, but buy. The sooner one is in the self storage business, the sooner you are creating the wealth and the experiencing the fulfillment this industry offers.
