SSSE’s core values are Fun, Integrity, Drive, and Others-First. As part of our commitment to Others-First, we strive to educate our investors, partners, and the general public about self storage. The Roman philosopher Seneca once said, “Luck is what happens when preparation meets opportunity”. This Frequently Asked Questions page is to serve as preparation for anyone interested in learning more about self storage and SSSE. The opportunities come when you sign up for SSSE’s investors list or buyers list by clicking the links in our menu bar. We hope to be lucky enough to work together.
If there are any questions that you have that are not answered below, please contact info@ssse.com
How do you price or value a self storage facility?
We price a self storage facility based on 3 different methodologies: financial, replacement, and highest use. Financial valuation is the most common and widely used methodology since self storage is a commercial real estate asset and commercial real estate is typically traded based on capitalization rates or “cap” rates. Determining a cap rate is taking the capital deployment (i.e. the purchase price) and dividing by the net operating income. It results in a percentage, like an 8% cap rate.
Net operating income is calculated by the annual gross operating income- all of the revenue that a facility generates before expenses- and subtracting the annual expenses the facility experiences. This results in the net operating income figure or “NOI”. Debt servicing is not included in the expenses used for calculating net operating income. Once you have a net operating income, you can reverse calculate the value of a facility if you establish what the market cap rate is. If it’s a nicer facility in a nicer, more populous area, it will most likely trade for a lower cap rate and thusly a higher premium.
A different valuation methodology from financial is replacement cost. This methodology is often best used for severely underperforming facilities, recent builds, or facilities in lease up because their financial performance may not be an accurate assessment of its current or future value. For instance, if you spend $10 million building a beautiful ground up development of a Class A self storage facility, and it just received certificate of occupancy so it is 0% occupied, financial valuation of the facility would put it at a value of $0. Actually less than $0 because there are expenses like property taxes and insurance that make it a negatively performing financial vehicle. 3 years from certificate of occupancy when the facility is leased up and performing, it now can garner a financial valuation of higher than $10 million potentially. Replacement cost valuation looks at how much it would cost to rebuild a facility using current construction costs but factoring in the wear and tear that the subject facility has experienced. So in that same scenario that we just discussed of the $10 million dollar new build facility, a replacement cost valuation would account for it costing $10 million to build. But now, construction and land costs could be higher and the fact that its already built as opposed to having to go through planning, zoning, and construction, provides a premium, so the replacement cost valuation could be even more than $10 million and it could make sense for the owners to sell as-is instead of leasing it up for a financial performance valuation. That’s not to say that people don’t buy facilities based on pro forma, or the potential financial performance of a facility. We certainly agree that should be accounted for in any valuation methodology, but we are not of the mindset where we want to pay the previous owner for our future work dollar for dollar.
Besides the financial and replacement methodologies we use to price and value self storage facilities, there is the highest and best use methodology. One of the benefits of self storage is that it can be built in a number of ways. If you have an empty box, it can typically be filled with smaller boxes making self storage. Highest and best use takes a look at the current performance and use of a property and determines if there is a better use for the property that would result in better performance. For instance, this could be converting non-temperature controlled self storage into temperature controlled. It could be taking larger units and making them into smaller units by using dividing walls because there is pent up demand for smaller units in the market and the rental rate per square foot is higher with smaller units. The most common scenario is a warehouse that needs to be converted into traditional self storage lockers as opposed to a wasted open space that is inefficient in its rental potential. Or a vacant piece of land that could have self storage built on it. Vacant land is not the highest and best use of that parcel. By changing the use to the best use of a property, it can bring a higher value to the property.
With these three different valuation methodologies- financial, replacement, and highest use- we can accurately value any sort of self storage property. Stating the obvious, the highest price with the best terms will usually get the deal done. So we employ these three different valuation methodologies to determine which route will allow us to make our best offer with the highest chance of getting accepted.
What cap rates do self storage facilities sell for in 2023?
The subject of self storage facility cap rates is one that does not age well. The bottom line is that self storage is a commercial real estate asset that has performed the best out of all real estate asset classes through recessionary periods so while other cap rates may be negatively impacted in the upcoming years, we believe that self storage will fair the best. We approach self storage cap rates from a 9 category matrix. There are 3 types of markets and 3 grades of self storage. Primary markets, secondary markets, and tertiary markets. Primary markets are major cities with high population density. We categorize that as populations of 250,000 or greater within a 10 minute drive time. Secondary markets we categorize as populations of 75,000 people to 250,000 within a 10 minute drive time. Tertiary markets are anything below that and because of the smaller populations, the density is usually less and it causes the trade area to increase sometimes to a greater than 10 minute drive time.
Class A self storage is mostly found in primary markets but we are seeing it more and more in secondary markets as the REITs and other institutional players expand out of the saturated primary markets into secondary markets. Class A is going to be newer, more expensive build types, multi-story, and temperature controlled. Class B is going to be slightly older, a mix of multi-story and single story drive up, with amenities like paved aisles, automatic gates, and potentially temperature control. Class C is going to be pretty much everything else: older drive-up units, possibly unpaved with gravel, compacted substrate or hopefully not just mud and grass. It is not an exact science and there is the largest range of quality facility within Class C which prompts some groups to use additional letters.
As you can imagine, a Class A facility in a primary market is going to trade at the lowest cap rate meaning that it is valued the highest, with the highest premium paid by buyers. A Class A facility in a primary market is going to trade at a lower cap rate than a Class A facility in a secondary market because of the security that a greater population and hopefully corresponding demand provides. So the Class C facility in a tertiary market is going to trade for the highest cap rate, or the lowest premium, because it is not as pretty of an asset, with potentially more risk.
We love to buy existing Class C and Class B self storage facilities for value add investment where we can improve their performance or even improve their asset class categorization. We like to build Class A self storage facilities because the premium to buy is incredibly steep so we are able to build them for less than purchase, lease them up, and either refinance at stabilization or sell them to market at the premium that grade asset garners. Historically, we have seen Class A facilities in primary markets trade for as little as 3% cap rates as long as there is room for increasing the financial performance. Over the past 3 years, we have bought Class C facilities in tertiary markets for as high as 12% cap rates. The rest of facility class and market combinations fit within that range, but now cap rates are rising because of interest rates.
Cap rates typically float above interest rates because of cash flow needs. So with the drastic increases in interest rates over 2022, we are seeing cap rates for all self storage facility grades and locations slowly rise to meet the higher interest rates. There is a lag in cap rates increasing and it is not directly proportional to the interest rate hikes because self storage is such a highly desired real estate asset especially for its recession resilience. As a result, we are seeing the highest valued self storage facilities trading at above 5% cap rates at the start of 2023.
The relationship between self storage facility values and interest rates can boil down to debt service coverage ratio (DSCR). Debt service coverage ratio is the calculation of net operating income versus debt payments. If the net operating income and debt service costs are exactly the same, it would be a DSCR of 1. Lenders typically want to see a DSCR of at least 1.25 so there is a buffer between loan costs and revenue from the facility, meaning that the net operating income of a facility can more than cover the debt payments. So as the cost of real estate loans go up with interest rate increases, the value of self storage facilities and other commercial real estate can go down unless the net operating income also increases to maintain bank required debt service coverage ratios.