When you look at most listings for self storage facilities, you will note that a common term used to describe them is their “cap rate”. So what is a “cap rate” and how do you know when it’s too high or too low?
What is a “cap rate”?
A cap rate is simply a mathematical expression of the net income of the property divided by the price. Why is that important? Because it represents how fast the property pays back the purchase price – in other words how much income you are buying for that price. For example, if a property has a 10% cap rate it means that the property can pay back it’s purchase price in 10 years. If it’s a 5% cap rate, then 20 years. Since buyers are looking to attain an income stream, a 10% cap rate is superior to a 5% cap rate since it’s effectively double the income stream.
How does a cap rate impact your financial returns?
Cap rates have an important tie back to many areas of property performance measurement. Not only does the cap rate give you an idea of how much income you’re buying, that income stream has critical impact on everything from getting a lender to make a loan, to cash-on-cash return, to cash flow. That one statistic has a huge meaning, kind of like your pulse at the doctor.
What is spread?
One of the most important aspects of a cap rate is the power it can unleash when sensible leverage is added. This difference between the cap rate and the interest rate on the loan is called “spread”. Here’s the basic formula you need to know. If you have a bank loan of 70% to 80% LTV, and a 3-point spread, then you’ll have a cash-on-cash return of roughly 20%. That’s living the dream of income property, as a 20% return is roughly ten times more than what you can make in a CD, in an asset that is real-estate secured (unlike a stock that has no inherent value and could plummet to zero at the drop of a hat). Using leverage, your total return spikes significantly based on the spread.
How do spreads impact your financial returns?
Let’s look at a sample deal. If the storage property is costing $500,000 and has a $50,000 per year net income, then the cap rate would be 10% ($50,000 divided by $500,000). Assuming a loan of 80%, which would be $400,000, you would have a down-payment of $100,000. If the interest rate on the $400,000 loan is 7% (to create a 3-point spread) then here’s how the numbers work out:
Price: $500,000
Down payment of $100,000
Note amount of $400,000
Interest on loan annually at 7% is $28,000
Net income from the storage property (revenue minus expenses) is $50,000
Net income after loan interest is $22,000 (which is $50,000 minus $28,000)
Return on your $100,000 down payment is $22,000 per year = 22% cash-on-cash return
That’s the simple formula to hit big returns.
What are your goals?
The proper cap rate to buy a storage property at is also a function of your goals. The lower the cap rate, the lower the expected return levels. So what are you trying to achieve? If the goal is 20%+ returns on your down payment than you need a 3-point spread. If you are willing to hit lower numbers, then you can go lower on the spread. Only you can set your expectations.
One more item: can you raise revenue swiftly?
Another important item to discuss is your ability to rapidly – and significantly – raise net income on that property, typically through higher occupancy. Let’s assume, for example, that mom and pop are terrible operators and have 50% vacancy despite the fact the rest of the market is at 75%. So you model what would happen if you immediately get an internet presence for the property and a stronger sales plan and boost the occupancy to 60% immediately following closing. That means you could buy this property at a lower cap rate and still hit your targets after your fix its deficiencies. So sometimes the going in cap rate has not bearing on the cap rate after only a few months of operation.
Conclusion
Cap rate is an extremely important tool in evaluating which storage property to buy. But there are many items that will influence that cap rate and its impact and you need to understand these to make a good buying decision.