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.