I don’t use CAP rates much when thinking about self storage, at least when I am buying it.
In my opinion, today, they are misleading, not accurate, and not a good way for me to relate the value of a facility. At least not the way they are being used today in our industry.
If you are not sure what we mean by CAP rates, here is an episode on it. They are a basic tool used in the commercial real estate industry to determine value.
Now don’t get me wrong, I am not railing against them, and they have their place. However, for self storage acquisitions, especially how Brokers use them today, for the most part, they are meaningless.
Why CAP Rates in Self Storage Are Problematic Today
Let me start by saying I am not an anti-Broker. I am a commercial real estate agent. They provide lots of value, and we use them.
But how self storage is valued today for marketing has gotten very weird.
A CAP rate is, in essence, the current return on the net operating income of a property that a ready and willing and able buyer is willing to pay for it.
Let’s unpack that.
There are three main components to what we just said.
- The income.
- The operating expenses.
- The rate of return on that net income (gross income less operating expenses) a buyer will accept, and the value they will pay to get that return.
Let’s look at a triple net lease deal, say a Walgreen drugstore. CAP rates are very applicable here in determining what I will pay for that investment.
If the store is 5,000 square feet, and the rent is $20 PSF, the income is $100,000. The tenant pays all expenses, so the net operating income (NOI), or income less operating expenses, is $100,000.
Now, if a ready, willing, and able buyer in today’s market is willing to pay whatever it takes to get a 5% return on that $100,000 cash flow, they are willing to pay $2,000,000 (100,000 divided by .05).
Now let’s consider any self storage offering memorandum (OM) you see today.
When a Broker tells me they have a facility listed at a 6% CAP rate, I have to ask (unlike the Walgreens) a 6% CAP rate on what?
- Previous calendar year?
- This year annualized?
- Trailing 12 months?
- “Proforma?”
Any answer I get today is meaningless because if on the previous calendar year, the Broker has “adjusted the numbers, to the market.” Especially the expenses.
Same with annualizing this year’s NOI. Same with trailing 12 months.
And the “Proforma” is a whole other can of worms where one has to dig into each and every assumption, and they are never the ones we use. So I don’t look at them, ever, unless I am trying to get a property tax number or something.
So, a CAP rate on what? That is what I end up asking a lot, and I realize whatever the answer, it does not mean a lot.
I use CAP rates today to determine future values for myself after we have completed our value add play.
Now I know the “values” created by these calculations are only estimates, but this is how they are really used by us today. Not on what we will pay for a project.
What We Do Use
I teach people to use today to figure out what they can pay for a facility or opportunity and utilize the benchmark numbers in their business strategy.
For everyone, that is different. For us, it is different today than it was five years ago.
We are not going into it here, but in my getting started series, we do. We dive deep into it in the Bootcamp I teach.
Why you are getting in self storage will determine to a large degree, what your benchmark numbers are.
For example, in my case, I woke up and realized I had no retirement plan and needed to create money, serious money, over the next decade.
I realized I knew self storage to some degree, and that could be my vehicle for creating the money I needed. However, I didn’t have enough money to buy enough self storage to achieve my financial goal, so I had to use other people’s money.
So that was part of my business strategy, and to a large degree, determined my benchmark numbers.
For me to use other people’s money today, I have to pay them, let’s say an 8% preferred return on their money. In other words, the first 8% of distributable cash goes to the people who put in the cash.
If you are using your own money, it is the same principle. What minimum return on your cash do you expect?
I also realized I needed to get them their investment back in five years or so. Investors generally do not want their money tied up in our deals for a decade.
So those are my two main benchmark numbers, an average minimum cash-on-cash return of 8% and the ability to refinance (or sell) the project in five years and give our investors their cash back.
Our business strategy calls for a refinance when it is time to give the investors their money back, and then we, as sponsors, get the majority of the cash flow with the investors staying in the deal if they want. They get an ongoing 30% to 35% of the cash flows and upside.
With these two benchmark numbers, I could analyze any deal, do my value-add play, and fairly accurately determine what I could pay for an existing facility in order to hit those two benchmarks.
I can be looking at the same deal as someone else and pay, let’s say, 90% of the current asking price, while someone else with a different set of benchmark numbers could pay a different amount.
Both would work. Trying to determine what I can pay, especially for a value-add play using a CAP rate, is for all practical matters today, not very usable. At least for us.
Capital Stack
Let’s look at another concept to use.
The buzzword today is “capital stack.” Sounds impressive, doesn’t it?
It just means the money in the deal.
How I relate to the concept is what is my cost of capital in the deal and how much more will the income from the project be over the cost of the capital stack.
Let’s take a look.
If my equity costs me 8%, and that represents 25% of the capital stack, and the loan is at 4% interest on a 20-year amortization. The loan represents the other 75% of the stack (bank money is the cheapest cash in the capital stack there is).
So what does this deal cost me?
Let’s say there is a facility for sale, which is 30,000 square feet and cost us $1.8 million. Who cares what the “CAP rate” is in the package?
I determined I can add another 20,000 square feet of self storage, there is demand, and the cost for the expansion is $55 per square foot. The market rate for a blend of 30% climate-controlled expansion, with the balance being non-climate-controlled space is $12.50 PSF.
The cost of the project would be $1,800,000 acquisition plus an additional $1,100,000 for the value-add play, totaling $2,900,000.
My capital stack looks like this:
| Amount: | Yearly Cost | ||
| Equity: | $725,000 | $58,000 | (8% Return on Equity) |
| Loan: | $2,175,000 | $158,161 | (Loan details above) |
| Capital Cost: | $216,161 |
My cost of capital in this deal is $216,161 per year.
Once I have completed my value-add play, the numbers look something like this:
| Gross Potential Income: | $625,000 | (50,000 x $12.50 PSF) |
| Stabilized occupancy: | $550,000 | (88%) |
| Operating Expenses: | $220,000 | (40%) |
| NOI: | $330,000 |
So my cost of capital is $216,161, and my income will be $330,000. Now there will be a capital reserve fund we set aside, but in essence, we will be getting an additional $113,839 profit over the cost of the capital in the deal.
Would you do that deal? We would.
What if instead of 8% on your equity, you demand 12% or the market rents were $7.50 PSF?
Re-run the numbers and see what you can pay for the existing facility.
Conclusion
This is how we decide what we can pay for self storage today, benchmark numbers, and income over the cost of the deal.
We never use CAP rates in determining what we can pay anymore.
I am interested in your thoughts and what you use in deciding what you can pay for a self storage deal. I know there is more for me to learn and absorb as I travel through the world of self storage.
I hope to see you on that road somewhere.
