Introduction
In the world of self-storage investments, few concepts are as widely discussed and misunderstood as capitalization rates or CAP rates.
I don’t think I have really seen an accurate one in an offering memorandum since…well….ever.
I’ve seen firsthand how these figures can be manipulated and misused, leading to confusion and potentially costly mistakes for investors
In this episode, we’ll peel back the layers of misinformation surrounding CAP rates and explore their true relevance, as I see it, in evaluating self-storage opportunities today.
Understanding CAP Rates
At its core, a capitalization rate represents the rate of return on a real estate investment based on the income it generates.
However, the devil lies in the details. You must look way beyond what is just in the OM (offering memorandums).
So, let’s explore what makes up the “rate of return” and what investment creates. A rate of return on what?
Think of the last appraisal you have seen.
Appraisers have three basic ways they determine value:
- Comparable sales.
- Income approach.
- Replacement value.
Most appraisals will have all three.
Depending on what is being appraised, appraisers weigh one of the three income approaches more heavily.
Houses, for example, the comparable sales approach is given the most weight in determining value.
For income-producing real estate, and self-storage falls here, the income approach is given the most weight.
So, how does one calculate a value using a CAP Rate?
Here is how an appraiser does it.
They will get the last calendar year and the trailing 12 profit and loss statements (last 12 months).
They will take income, usually rent, less operating expenses (cost to operate the project not including capital improvements and loan) and calculate a net operating income (NOI).
The game for an investor is to get the real NOI. More on this in a minute.
Now, what will a ready, willing, and able investor pay for that NOI?
Said another way, what rate of return will a ready, willing, and able investor expect in the current market on that NOI?
That rate of return, CAP Rate, will tell someone the value or what they can pay for that cash flow.
Appraisers look to determine the “market CAP Rate” at the time of an appraisal.
For self-storage today, it appears to be around 7% today for most storage projects. For high-quality projects in large markets, it may be less./
And one last note on this long-winded explanation: we use NOI (income less expenses) because it is the same number regardless of whether someone pays all cash or puts 100% financing on it.
Cash-on-cash returns are determined by after debt and reserve funds are paid, but value is determined by NOI.
The Abuse
Where we need to be aware if is the quoted CAP Rates in these OM’s (offering memorandums).
Again, what an appraiser does is take let’s say trailing 12 Profit and Loss statements, see what the NOI is and apply a market CAP Rate to determine value. For example:
| Description | Amount |
|---|---|
| Income | $750,000 |
| Operating Expenses | $307,500 |
| NOI | $442,500 |
| CAP Rate | 7% |
| Value | $6,321,429 |
But once the listing agent gets through with their “market adjustments,” which is shorthand for removing operating expenses and/or raising income, they then apply a CAP Rate to this newly created NOI.
The same project above (can look like this:
| Description | Amount |
|---|---|
| Income | $787,000 |
| Operating Expenses | $287,200 |
| NOI | $499,800 |
| CAP Rate | 7% |
| Value | $7,140,000 |
We will see a 7% CAP and think this is not overpriced, or at least that is the goal.
So, a word of advice: never assume the “proforma” in these OMs is accurate.
Remember, the listing agent works for the Seller and, in most cases, has no fiduciary relationship with you as a buyer.
That is why I tell everyone I am working with or in the Bootcamps I teach to use their own numbers.
I usually limit the numbers I get from the OM, at least expense-wise, to the property taxes, the utilities, and the insurance. Then, on the last two, I usually adjust them upward.
Base the rest of the operating expenses on how you will run the project.
You may say, well, I don’t own one, so I am unsure how to run the project.
What I did was use industry numbers. I got them from the Self-Storage Almanac until I had my own.
But you can price out website costs, see what wages are in your area, check what insurance will cost, etc.
But for short cuts, I often used the almanac. You can get it from MSM.
Final Note About Relevance Of “Going In” CAP Rates
Now, with all that said, for me, the CAP Rate I buy on is mostly not the main criteria I use in determining what I can pay.
If I were just buying a project and doing nothing to improve it, the CAP Rate would be more important to you.
But it has been over ten years since I have been able to do that in the self-storage space.
As small investors, we almost always have to do some value-add play to improve the value.
What determines what I can pay for an existing project is what the project will be worth after I do my value-add play, not a CAP Rate on existing income.
The future NOIs I will create, with an applied CAP Rate to determine value, are way more critical to my determining what I can pay than an applied CAP Rate for the previous owner NOI.
So, I have just gotten into the habit of answering the question, “What was your going in CAP Rate?” by saying, “I don’t know.”
But the one thing I do know is that whatever is in an OM is not the accurate NOI.
Our job is to determine that, then determine what the NOI will be after we do a value-add play, and based on the returns we need (to be determined before we analyze anything)…that tells me what the current project is worth to me today.
Do that, and you will have a long, successful future in this fantastic business of self-storage.
