Capitalization rates can be confusing, but they’re essentially a measure of investment risk. Learn how they’re used by investors and brokers to determine self-storage facility value.
Let’s talk about the capitalization (cap) rate, that fuzzy, malleable metric outside your control that seems to yield a different answer each time someone asks, “How much is my self-storage facility worth?” Simply put, the cap rate is a measure of risk. Mathematically, it gauges the relationship between net operating income (NOI) and facility value. When you increase NOI, an increase to value directly follows.
To get a firm grasp on the cap-rate concept, we need to split the context of the conversation between micro and macro. The micro portion can be summarized as, “Cap rates drive the value of your facility,” while the macro portion is, “The market drives cap rates.” Together, this tells you: “The market determines the value of your facility.” No doubt, you already understand that notion, but let’s break it down, factoring in the cap rate.
Understanding the Micro
At the micro level, the cap rate is your friend. It’s the great and divine multiplier that turns $1 of profit into $20 of value, or $5,000 into $100,000. How?
Let’s say you rent your 10-by-10 self-storage units for $100 per month. This will increase your bottom-line profit by $1,200 annually. If you’re in the market to sell or refinance your facility, a buyer or lender won’t just look at the value of that unit in today’s terms; they’ll project the value of that lease 15 to 20 years into the future. This is because they believe that if that unit can be rented today, it’s highly likely it can be rented tomorrow. So, $1,200 each year factored over 15 to 20 years is a value increase of $18,000 to $24,000! Remember, that’s just for renting a single $100-per-month unit.
Of course, this works both ways. If your occupancy is low, or takes a dramatic dip, your facility value will also take a hit. This is because investors (whether buyers or lenders) will lack confidence in the property’s ability to get and stay full. A certain portion of units aren’t rented now, so they have to wonder, why would the future look any different than today?
Applying the Macro
In the big picture, cap rates are used by investors to indicate the level of risk among a group of commercial real estate assets. For example, they might want to compare self-storage facilities in Phoenix to those in Tampa, Fla. The cap rate helps show how risky an investment is, based on the market. If investors think Tampa is a better bet than Phoenix, they’ll be willing to pay more for a Tampa property than they would for an exact replica in Phoenix.
Just keep in mind that your local market is just one of dozens of attributes investors will use to assign a cap rate to your property. If two brokers give you two different opinions of value for your facility, even though you’ve given both the same NOI, it’s likely because they’re applying two different cap rates based on facility features they’re seeing (or ignoring).
For example, let’s say your facility offers outdoor RV parking. This product typically fetches a lower value (higher cap rate) than self-storage. For the sake of easy math, let’s say it generates half your income. The market will bear a 10 percent cap rate on the RV parking and a 5 percent cap rate on self-storage. This means your blended cap rate is 7.5 percent.
One broker may astutely make note of this investment market knowledge and quote your value with the blended cap rate, while the other may just use the 5 percent self-storage cap rate for the entire facility. If you have $200,000 of annual NOI, the broker who acknowledges that outdoor parking is worth less than self-storage may quote a price of $2.7 million, while the other may quote $4 million. That’s a huge differential.
Improving Your Cap Rate
All this begs the question: Is there anything you can do to affect the cap rate assigned to your self-storage property? If the cap is based on sales comparables (comps) for facilities with similar features, then perhaps you can change the narrative by highlighting or altering certain site attributes, thereby giving the property a different set of relevant comps.
For example, if you own an aging facility in a tertiary market, you likely have a cap rate somewhere near 7 percent. But if that market sits strategically between two primary markets, plus the facility is on a major thoroughfare and all that’s needed to be aesthetically pleasing is a fresh coat of paint and a drive-aisle overlay, then you might be able to earn a 6 percent cap rate. In this example, lowering the cap rate by 1 percent increases facility value by $238,000 for every $100,000 of annual NOI!
At the end of the day, cap rates are just a story reduced to a single number intended to represent a level of risk. All stories are subject to fuzzy, malleable embellishments. It’s just a matter of who constructs the most convincing narrative that counts.
Source: “Understanding the Role of Cap Rates in Determining Self-Storage Facility Value“