How To Use Self Storage Cap Rates To Invest

self storage cap rates

Do you remember what the first cell phones looked like?

Miami Vice

They reminded me of some type of military satellite phone that were stored in bags that you could carry on your shoulder.

I first saw one watching Miami Vice as a kid when Crockett (or was it Tubbs?) was driving around in their Ferrari making calls. 

Those guys were too cool!

Just like the cell phone industry, the self-storage industry has dramatically changed over the last 40 years. Especially when it comes to the design and amenities offered to their customers.

Storage units of the past were small, single buildings with:

  • few amenities
  • garage doors that roll up
  • occasionally a fence around the property
  • little to no security

Many of these older buildings were planned when landowners had leftover irregularly shaped parcels of land and didn’t know what else to do with them. 

My how things have changed. With the rise in online shopping, Americans had easier access to buy things but then they ran into a problem….where to store all of this extra stuff?

You guessed it, self storage. But instead of them being tucked behind your grandma’s barn, they’re now located in heavy traffic areas alongside grocery stores and big box retail.

Real estate investors have also seen an uptick in their value as they’ve become more modernized. I recently traveled to Dallas and noticed several climate controlled, multi-story self-storage facilities.

They were so big that at first, I thought they were apartment buildings. Several had other businesses attached such as U-Haul rentals. This increase in technology and amenities have dramatically increased the revenue potential thus making it one of the hottest asset classes in real estate today.

Today, millions of people and businesses use self storage to store their supplies, furniture, materials, vehicles, etc.  These facilities play an essential role in people’s lives due to the major need for secure places to store household goods.  

As you can imagine because of this extreme demand, self storage can be an excellent investment choice. 

Typically, storage facilities cost less than apartments and can be purchased with a smaller amount of money versus other asset classes.

Whether you choose to become an active or passive investor, it’s crucial to understand the financial metrics involved such as the cap rate which is used to indicate the rate of return expected for a particular property.

Cap rates have become increasingly important to self-storage developers as the industry has become more competitive.

In this article, we’ll take a closer look at:

  • self storage cap rates
  • how they are calculated
  • why they are used
  • what’s are good self-storage cap rates
  • the profit margin on storage units
  • are self-storage properties a good investment

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What Is a Cap Rate?

A cap rate, also known as capitalization rate, is a metric used to evaluate the profitability of a real estate asset such as self storage assets.

Investors use cap rates to quickly compare the return on investment (ROI) on self storage properties which may vary by rental rates, construction type, location, and other differences.

It’s also an indication of what return an investor is willing to pay when acquiring a self-storage property.

Typically speaking:

  • the lower the cap rate the higher the value
  • the higher the cap rate, the lower the value

One other thing to consider is that cap rates don’t factor in any debt service (mortgage payments) as it assumes an “all cash” purchase of the property.

How Are Cap Rates Used?

Some investors rely heavily on cap rates and look for properties with cap rates of 8% or higher. However, that’s just one data point (from only one particular year) on an asset.

Cap rates don’t take into consideration other factors such as:

  • loans
  • time value of money

When comparing different properties in the same market, cap rates can be very useful.

As an example, if you’re looking at investing in self storage units that have a cap rate of 7%, in comparison to other properties that have cap rates of 6.8%, 7.2%, and 7.4%, then your property’s cap rate is fairly comparable.

A red flag could be if it had multiple points higher or lower than the others in the area.

Cap rates can also be a good general measure of the asset class and corresponding risk in general.

Assets with high cap rates tend to be in developing areas and those with lower rates may be in more established areas.

As with most investments, higher rate means higher risk as well.

How To Calculate Self Storage Cap Rates

Cap rates are calculated by taking the net operating income and dividing it by the market value (sales price) of the self storage facility.

Cap rate formula:

cap_rate_formula

If the net operating income (NOI) isn’t provided, it can be calculated by taking the income generated by the self-storage facility (rent, locks, boxes, etc.) and subtracting out the operating expenses (maintenance, repairs, landscaping, taxes, insurance, payroll, capital expenditures, vacancy, etc.)

Conversely, you can determine facility value by dividing the NOI by the cap rate.

Remember that mortgage payments (debt service) and any depreciation previously taken are not included in the NOI calculation.

Cap Rate Example

Dr. S is starting to feel the effects of practicing dentistry in his back and neck and decides to get into real estate investing. He’s heard that the self-storage asset class is the place to be and gets in touch with a self storage broker for help. 

He finds a self-storage facility that has a gross income of $200,000 and operating expenses are $75,000.

He’s excited to use some of his newfound information (from some DebtFreeDr guy) and determines the NOI is $125,000 ($200,000 – $75,000).

His broker informed him that comparable self-storage units of similar size, condition and location are selling at a 6.5% cap rate.

For Dr. S to figure out what the proper value/sales price would be, he would divide the NOI ($125,000) by the cap rate (6.5%).

$125,000/.06525 = $2M

He’s now able to determine that the value of the property is $2m.

If you were to look at this in reverse and were selling a facility for $2m and wanted to determine the cap rate, then you’d divide the NOI ($125,000) by the sale price ($2,000,000). That comes to .065 or 6.5%.

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Why Are Cap Rates Used?

Here’s 3 reasons why cap rates are used in self-storage transactions.

#1. Potential income

Self storage properties have their value based on their income potential along with the perceived risk of maintaining that revenue.

The cap rate takes this income and gives it a value.

#2. Versatility

Because a cap rate is considered income only, it can be used to compare other real estate types along with other alternate investments like:

  • stocks
  • bonds
  • businesses

#3. Comparables

You need a method to compare properties with different locations, physical conditions, and level of management as no two self storage properties are exactly alike.

Depending on the level of risk involved in maintaining a facility’s future income stream, the cap rates are adjusted up or down.

Here’s two examples that should help visualize this concept:

Self Storage A

This is a 20-year-old facility out in the country with nobody onsite to manage.  (8% cap rate)

Risk factors involved:

  • plenty of adjacent land for competition to build on
  • older property condition (possibly run down)
  • low population

Self Storage B

This property is only 2 years old in a booming suburb of North Dallas. It’s equipped with an on-site manager and offers several amenities such as climate-controlled storage. It’s valued at a 5.25% cap rate.

The upside to this site is the number of customers it acquires monthly due to population growth. Also, it’s new construction that’s professionally managed with limited barriers of entry for competitors.

Here’s several factors that demand a HIGHER cap rate thus lower value:

Thus, factors that demand a higher cap rate (lower value) include:

  • Poor visibility
  • Low occupancy
  • No management office
  • Declining population base
  • High competition
  • No security
  • Poor facility design

Here’s factors that lower the cap rate (increase value):

  • Excellent visibility and access
  • Newer construction
  • Security measures
  • Professional management
  • Well-designed layout
  • High occupancy
  • Low delinquencies

How To Increase the Cap Rate

Instead of investors asking how the developer plans to increase the cap rate of a storage facility, they should focus more on them “improving” the cap rate.

Remember, the HIGHER the cap rate, the LOWER the value of the property.

The focus shouldn’t be on increasing the cap rate, but instead, improving the property which in turn decreases the cap rate. 

As we’ve discussed in the past, there’s several ways to increase a property’s value with the most common way to add value (value-add improvements).

The way to do this is through improvements to the property such as:

  • painting
  • new roof
  • adding/updating security
  • adding climate control option

By making these types of improvements, you’ve now opened up to buyers with more access to capital who will pay more per square foot. They’re also paying for the risk the seller endured in repositioning the asset. In this situation, everybody wins as the cap rate improves.

History Of Self-Storage Cap Rates

As with any type of real estate asset class, self storage cap rates rise and fall as the market cycles evolve. But in the last 15 years, we’ve started to see a decline in these rates mainly due to the fact that the self-storage industry has proven resilient.

We’ve particularly been able to see this firsthand in both the 2008 economic downturn and more recently in the 2020 pandemic.

Even after these two major financial setbacks for the United States, self-storage has continued holding its value as collections remain HIGH.

Many real estate investors are taking note of this industry as providing a more stable form of cash flow than when it had less of a history behind it.

Even the BIG players are getting into the game as more of their capital is starting to enter the market. 

Institutional investors 

Institutional investors such as Blackstone are beginning to invest in self-storage. In 2020, they invested $1.2 billion in Simply Self Storage which is one of the top five private owners of self-storage and operates a high-quality portfolio totaling eight million square feet across the U.S.

Many of these big players 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.

Something else causing cap rates to decline (cap rate compression) is the increased diversification of the self-storage industry.

We’re beginning to see more income options, such as insurance for tenants, which is something that didn’t exist on a few years ago.

Self-storage facilities are now beginning to require this tenant insurance which increases their NOI and value in the long run.

Bottom Line

More people are learning about investing in the self-storage market as a way of diversifying and mitigating risk in their portfolios.

As this increase continues, you can expect to see an exacerbation of cap rate compression. In turn, this will make it harder to earn the double-digit profits that so many have realized early-on.

Also, it will make it more important to partner with developers and operates who understand the self storage industry.

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