"Cap rates" are a metric used in commercial real estate to evaluate a deal's potential profitability. Like other product types, cap rates are an important metric that self-storage developers consider when looking at various deals and opportunities. Cap rates have become increasingly important to self-storage developers as the industry has become more competitive. Self-storage, once considered a niche in an otherwise alternative asset class, has come into its own as these facilities have become more modern, sophisticated and accordingly, more lucrative to investors of all kinds.
In this article, we look at self-storage cap rates, including how they are calculated, how they are used by self-storage developers, and how they can be influenced. We will also look at the pitfalls of using cap rates as a metric alone, and why they are best used as a complement to other real estate valuation tools. Read on to learn more.
Overview of the self-storage industry
The self-storage industry has changed dramatically over the last 50 years, particularly as it relates to design and the level of amenities these facilities provide. Long ago, self-storage was comprised of one or more buildings with roll-up garage doors, little-to-no amenities, and maybe a fence around the property. Typically, security at these properties was fairly limited.
Self-storage buildings were often reserved for irregularly shaped parcels or otherwise forgotten plots of land that people struggled to develop for other uses. In many respects, they were the development of last resort when no other project would pencil out.
Fast forward to today. The self-storage industry is more than a cottage industry. Today, it's a desirable asset class. Self-storage is no longer tucked away on forgotten land. Today, self-storage is located in major markets, in heavily-trafficked areas alongside prominent uses like grocery stores and big box retail.
Self-storage facilities have also skyrocketed in value as they have become more modern. Today, self-storage facilities are often multi-story buildings featuring climate-controlled units of varying sizes. They have robust security features including things like automatic gates. Many are coupled with akin uses, such as U-Haul trucking facilities, to provide a one-stop-shop for those looking to move and then house their goods. All of these amenities have increased revenue potential, and, combined with a strong historical performance, these once-forgotten assets have become darlings for investors.
What is a cap rate?
A cap rate, which stands for capitalization rate, is a metric used to evaluate the profitability of a real estate asset. As described in more detail below, it is calculated using the ratio of NOI (net operating income) to value. For example, if a property has $100,000 in NOI and is valued at $1 million, it would have a cap rate of 10 percent. In this case, we would say that the investors are getting a 10 percent return on their money.
Cap rates are important to investors as every investor wants to know what sort of return they will make by investing in a specific asset. Cap rates are also a quick and easy way for investors to compare different opportunities. But comparisons have an evil side as well that we will discuss later.
One note to consider is that cap rates do not factor in debt load as any mortgage payments are deducted from the net operating income. Thus, the calculation assumes all properties are purchased with cash, which is rarely the case. Having said that, cap rates are still a useful tool for investors doing a high-level analysis, but why further analysis is generally warranted as investors move further into the due diligence process.
How to calculate cap rate
Cap rates are simply a ratio that looks at the relationship of net operating income (NOI) to value. Cap rates are calculated by dividing the NOI by the sales price as follows:Cap rate = NOI / Sales Price
This ratio is expressed as a percentage, usually somewhere between 3 and 15 percent.
Calculating the NOI is a critical piece of determining cap rate. The NOI is calculated based on the gross income generated by the self-storage property (rent, boxes, locks, trucks, etc.) and then subtracting out all normal operating expenses. This includes reasonable expenses for repairs and maintenance (e.g., landscaping and snow removal), management fees, taxes, insurance, payroll, capital expenditures, vacancy and more.
Depreciation and loan payments are not included in the NOI calculation.
A self-storage developer or investor can also determine a projected sales price by using NOI and cap rates. To do so, simply divide NOI by cap rate to determine the sales price.
What is spread?
Spread refers to the difference between cap rate and interest rate. This is the "spread".
A spread is an indicator of whether the money being earned by the property for the investor is greater than the cost of the money being borrowed. If the interest rate is higher than the cap rate, then the cost of the money being repaid to the bank is greater than what is being earned. This is an easier application to a stabilized property where revenue is only increased by annual rent increases. The property is going to be produce a nominally higher NOI each year because it is already leased to stabilization, no more building expansion is possible and the property is being run at maximum efficiency.
In the case of a value-add investment, the buyer intends to expand with more square feet or pump significant capital into the property, which will, in turn, dramatically improve the revenues. In this case, the price is reflective of the future upside potential, and therefore, the going-in cap rate is not the best indicator of the true value of the asset, some of which is future value. In this case, the spread is less relevant. For self-storage, the cash-on-cash returns provided annually or the return-on-investment, which accounts for the annual returns and the returns upon sale are more critical to measuring the health of a value-add investment.
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Cap rate uses in real estate
There are different ways to use cap rates in real estate. In short, they are used to translate income into value. However, cap rates can be used in more nuanced fashion.
For example, some investors will use going-in cap rates if they plan to buy and hold the asset without making any significant improvements. Meanwhile, a developer that invests in a Class C self-storage property might be more interested in the exit cap rate, or the anticipated cap rate after improvements have been made and the property is stabilized prior to sale. The exit cap rate is based on the sponsor's cash flow model six- to ten years into the future.
Calculating exit cap rates can be difficult, particularly for first-time investors. It really takes experience to project income based on expansion plans, rate increases, value of amenities and more. Exit cap rates must also account for the unknowns: pandemics, recessions, changes to the industry, you name it.
Regardless of whether a developer uses the going-in or exit cap rate, the cap rates can be used to evaluate both cash flow and end value and accordingly, the returns an investor might expect to earn if investing in that deal.
High or low cap rate: which is better?
In simple terms, think of the relationship to cap rates and property values as follows: the higher the cap rate, the lower the property value.
As for which is better, a high cap rate or low cap rate, it really depends on who is being asked. A seller wants the lowest cap rate because it means the property is highly valued. A buyer, meanwhile, will usually look for properties with a high cap rate because it means the property is undervalued and will sell for less.
Properties with both high and low cap rates can be equally attractive as investments. For example, an institutional investor looking for steady, "safe" cash flow might look for properties with low cap rates. These properties are usually already stabilized but in turn, are more costly. A value-add investor, on the other hand, might only seek out properties with high cap rates at stabilization because this accounts for the risk of adding the value and executing that business plan. Ultimately, the preferred cap rate really depends on a specific person's investment strategy, time horizon and risk tolerance.
Things to look for
When evaluating cap rates for self-storage properties, a prospective developer or investor will want to really drill down into the seller's P&L. They will want to understand what the owner is including for revenue and expenses, and then determine whether these are in line with market averages. For example, a mom-and-pop self-storage operator may be a long-time owner who does not take a salary. Instead, they live on-site in an upstairs apartment and take occasional distributions depending on the profitability of the facility at any given point in time. Therefore, there may be no payroll included in their cap rate calculation-which would not be standard in a commercially operated self-storage facility.
Similarly, the operator might not employ a third-party property manager. They might self-manage, something that institutional investors would not do.
Perhaps the owner does not have a line item for advertising. Maybe they have always marketed the property locally and through word-of-mouth. Their revenue numbers might reflect that, and revenue may be able to increase with more effective or more modern marketing strategies.
In any event, be sure to look at the details of the revenue and expenses because this will influence the cap rate calculation. Those looking to boost the cap rate will want to pay close attention to income and how additional income could be generated, as this will increase the sale value (exit cap rate) down the road.
Other things investors will want to look at include whether the local demographic is growing, demand for self-storage and whether there is increasing or decreasing competition in the marketplace.
How to increase your cap rate
Investors often ask how a developer plans to "increase" the cap rate of a self-storage facilities. Instead, they should be asking how to "improve" the cap rate. This is a critical distinction to make and is a result of the inverse relationship between cap rates and value we discussed above. The higher the cap rate, the lower the property value. Therefore, investors do not want to increase the cap rate, but rather improve the property which actually means decreasing the cap rate.
Now, there are many ways to increase property value (and decrease your cap rate). The most common way to improve cap rates is by investing in value-add improvements. This could be light value-add investments, such as replacing the roof and repainting the exterior, reformatting the layout of self-storage units, redoing the façade, and investing in new HVAC systems to allow for better climate control. Heavier value-add strategies often include adding all the modern amenities, adding a highly visible office with room to sell moving supplies, and building a three-story climate building on excess land to completely change the property from a series of older drive-up buildings to a Class A storage facility with some drive-up buildings to boot.
By improving the quality of the asset, this opens up to a buyer pool with more access to capital and likely lower cost of capital, who will pay more per SF for higher quality of the asset. They are also paying for the risk the seller endured in repositioning the asset. Everybody wins. In turn this improves (i.e., decreases) the cap rate.
History of self-storage cap rates
Self-storage cap rates move over time, particularly as market cycles evolve. In recent years, we have been experiencing downward pressure on self-storage cap rates. This is partially because, in both the 2008-2009 economic downturn and more recently, the economic downturn brought on by the pandemic, the self-storage industry has proven resilient. Self-storage continues to hold its value. Collections remain high. Investors see the asset as a more stable form of cash flow than when it had less of a history behind it. In turn, self-storage cap rates continue to go down.
Related, as self-storage continues to perform well, more capital is entering the market. More, and bigger, players are chasing these deals. Now, institutional investors like Blackstone are investing in self-storage - something we never would have imagined just a few decades ago. They are often overpaying for properties (supported by the low-interest rate environment) for the sake of diversification, and in turn, it is increasing values and driving down cap rates even more.
Another reason for cap rate compression is that self-storage income has become more diversified. There are more options for income, such as tenant insurance, something that did not exist ten years ago. Many facilities now require tenants to purchase insurance, which is an NOI boost and in turn, increases value.
The current self-storage market
Industrywide, the self-storage market continues to do well. One of the best sources for market information are the publications issued by self-storage real estate investment trusts (REITs). These reports typically come out on a quarterly basis, and consistently, self-storage REITs are reporting strong occupancies, strong growth, and strong collections. In many cases, self-storage facilities are outperforming developers' expectations.
Acquisition-wise, "good" deals are harder to come by, but transaction volume remains high. This is particularly true as more institutional investors enter the fray and pump capital into the marketplace. Sellers are often at a crossroads: do they sell now and cash in on high values, or do they continue to hold given strong cash flows, and hope that values continue to rise? And if they sell, given the high-valued marketplace, how can they reinvest that money? Some sellers have found a middle ground by partnering with developers in ways that allow them to remain in the deal, but who otherwise turn over control and operations to their partner.
Self-storage development and market trends
One trend we are seeing is that ground-up development has recently slowed. It peaked sometime between 2017 and 2019, depending on the specific market. Development naturally slows once it reaches a certain saturation point but exacerbating the decline of ground-up construction is that costs have continued to escalate. In many markets, it is now more cost-effective to renovate a property than to build new. Projects that were in the pipeline but put on hold during the pandemic may no longer pencil out as costs have risen, and today, are off the drawing board altogether.
Instead, many self-storage developers are turning to Class C properties that can be improved to Class A or B standards. These properties were generally constructed in the 1970s or 1980s and are in below-average condition. They are often self-managed by the owner or have no on-site manager at all. These properties represent a unique opportunity for investors seeking spread.
Self-storage risk factors
The biggest risk with self-storage development is increased competition. As noted above, development has slowed in recent years. However, in the leadup to 2020, there was significant new construction of high-tech, increasingly modern self-storage facilities that put downward pressure on occupancy rates and market rents. That said, self-storage is a hyper local industry. Any prospective investor will want to carefully consider local market conditions, including population growth, demographic profile, and current (or planned) competition to determine whether a particular location is justified.
To underscore this last point about competition: unlike apartment buildings or offices, newly constructed or renovated self-storage facilities are generally similar and offer the same types of amenities. Therefore, if a new building comes online, the owner might drop their prices to half of market rate just to fill their units. This will have a dramatic impact on your facility, as well as any others already operating in the nearby area. This is because, all else considered equal, users become laser focused on price and will lease the unit that's most affordable.
The self-storage market is becoming more mainstream. More people are getting comfortable with the asset class and are increasingly willing to invest, adding it to their portfolios as a way of diversifying and mitigating risk. As more people invest in self-storage, and as more capital enters the marketplace, we expect to see cap rate compression exacerbated. This will make it harder to earn the double-digit profits that so many self-storage developers realized early-on and will make it more important to partner with self-storage developers and operates who have a keen understanding of the industry - including the many ways to increase revenues and improve values.