Like any form of real estate, self-storage has its own unique boundaries on performance. So what are those? And where did those calculations come from? In this episode we’re going to review the basic metrics for storage investing and define those basic terms. If you want to know what your return on investment can be from buying a storage facility, then here it is.
Episode 2: How Much You Can Make – Defined Transcript
A cap can make your whole outfit and a CAP rate can make your whole self storage investment. This is Frank Rolfe, The Self Storage Investing Mastery. We're going to be talking today about the three basic metrics of measuring any real estate deal, but particularly those of a self storage facility, CAP rate, Cash-on-Cash return and cash flow.
Let's start with CAP rate. What is a CAP rate? Well, a CAP rate is best thought of as a fraction. You put the net income from the property on the top and the total cost of the property on the bottom, you divide the top by the bottom, and that gives you the CAP rate. Let's do a test. You have a property that makes a hundred thousand dollars a year, so that will be at the top of the fraction, a hundred thousand. And then it costs a million dollars. You put that on the bottom of the fraction. You divide a hundred thousand dollars by a million dollars and you get 10%. And that would be the CAP rate on that deal, is 10%.
Now, CAP rate is pretty easy to understand in the big picture because when you're buying the self storage facility, the higher the CAP rate the better. When you are selling the self storage facility, the lower the CAP rate the better. But there's a lot of things you need to know about CAP rates that fit in between that high and that low. The main item on a CAP rate is a CAP rate is given you a measurement of the performance of that deal and the CAP rate amount, and particularly the interest rate on the loan that you use to buy that storage facility, that difference between those two items is called spread. And spread is what will determine in many ways what your actual return will be.
All real estate is contingent upon leverage to some degree to make really high yields and storage is no different. So if you're buying something at a CAP rate, of let's say 8%, it's important that you try and have interest rate at 5% so you have a three point spread. Three point spread is what can get you a 20% Cash-on-cash return. Now, as you go down from there, the [inaudible 00:02:06] spreads, so does your overall return. If you're unable to have any spread between the CAP rate and the interest rate, then your CAP rate is the same as the interest rate. And if you pay all cash for the property, once again, the CAP rate is the same as the interest rate.
However, if you can get a one point spread between the two, then you'll make a high single digit Cash-on-Cash return. And if you can get a two point spread, then you'll make somewhere 12 to 15% Cash-on-Cash return. But that third point, that spread is what gets you a 20% Cash-on-Cash return, and for most investors, that's what they seek. Now, in most storage facilities, you're not going to get to three points immediately. You might be able to get one point and you might, in some cases, be able to get two points. You'll have to earn your way to the third and higher through doing a better job of operating the property. You're going to have to do a better job as far filling vacant spaces, you may have to raise your rents, you may have to cut costs, you may have to do a lot of factors. But what's important is that you buy properties that you can, after purchase, continually to groom and push up the net income, because as you do that, all that money goes to the bottom line and goes into your pocket.
So what are the CAP rates right now on storage? Well, I see them running from probably just a single digit spread, five or 6% in some markets for predominantly California markets, all the way up to, in some more rural locations, you may able to get much larger spreads. You might be able to get a three or four point spread in a small town storage facility. So, CAP rates are all over the map, but the key item is that they are still not as compressed as they are in apartments and other forms of real estate, where it's very, very difficult to do high yield. So you can still get a decent yield in storage if you are a good shopper.
Next up to bat is Cash-on-Cash return. Now, what does that mean? Why would I care about Cash-on-Cash return? Well, for many people, that's the most important item. That tells you what the return is on your down payment. So let's assume you found a self storage facility with a three point spread with a 20% Cash-on-Cash return and you put down $200,000. 20% on 200,000 is 40,000 a year. So that's what your Cash-on-Cash return would be, $40,000. Now, let's compare that to what would happen if instead you put your $200,000 over at the bank in a CD where you would only get a 2% return. So in that case instead of 40,000 a year, you would get 4,000 a year. Then it would take you 10 years to make as much in the CD as you can make in one year with a self storage facility.
So Cash-on-Cash for many people is very, very important. Once again, it all ties back to spread. It all ties back to leverage. If you have no leverage, if you just pay cash for the property, then your CAP rate is your total return. So if you bought it at a 5% CAP rate, you would end up with a 5% Cash-on-Cash return. That is not as impressive as if you throw some leverage behind it. Now it's important for us to note that leverage is a double edged sword. If you put too much leverage on something and it goes bad, it's woefully worse than if you didn't put any leverage at all. So we always suggest people use sensible leverage. That means borrowing at a rate of 70 to 80% of purchase price. That's what's reasonable. Always be worried in economic times in which you can do more than that. If you can do 95 or even 100% leverage, which is what happened in the single family home market prior to 2007, well, you saw the ending to that.
So sensible leverage is smart. You'll see a lot of the reads, real estate investment trusts in the self storage industry, they don't use more than 50% leverage if they even have that much. So Cash-on-Cash is a very, very important item because that tells you for the money you're putting down what you're going to get at the end. And I think for everyone that's important. It's also worth noting that one way that people really mess themselves up on both CAP rate and Cash-on-Cash is about lying to themselves on what the capital needs are of the property that they're buying. If you recall, we just mentioned that CAP rate is a fraction. It's the net income above the total price. If I alter the total price, I will have a huge impact right on the CAP rate, because now I have to divide that income by the new total price, which can lower my return substantially.
So whenever you're running the numbers on these things, you've got to make sure that you've taken into account not only what you're paying for the storage property, but any additional Capex you're going to do. Are you going to repay the parking lot? Are you going to paint it? All these various items have to be added into the lower part of the fraction and then divided through. If you do not do that, then you are effectively lying to yourself.
Now let's move on to cash flow. Now Cash-on-Cash return includes the principle portion of your mortgage payment. Now, that's called enforced savings because what the bank is making you effectively do is save that money in the bank. Now, some loans out there are interest only, and if you have an interest only loan, then they don't take out any principal. But by and large, most storage lending includes a principal payment with every monthly payment. And so the Cash-on-Cash return is the money that goes to you, but not necessarily that it ends up in your pocket, because part of that goes into the bank as enforced savings as your principal payment. So the cash flow component tells you truly how much money you can take out. It tells you how much that storage facility makes monthly and annually after both principal and interest. And for some investors, that's the key item they want to know. They want to say, "Okay, I know that I'm going to be getting a decent Cash-on-Cash return, but what is my cash flow?"
Well, to do your cash flow analysis, you're going to have to notice an important item. And that is basically what is the amortization of your note, because that tells you how much of your note will go towards principal every month. If you have a 30 year amortization, then it takes you 30 years to pay back the bank. If you take a 15 year amortization, then you pay back the bank twice as fast. But that means traditionally you may have twice as much going to them in the form of your principal payment. Therefore, there's less money that goes into your pocket.
It's also important to think of cash flow as something that's immediate gratification for good performance. If you buy a storage facility that is not running on all eight cylinders, perhaps mom and pop had never mastered the internet, didn't really know what they were doing on that front so they weren't doing good marketing and you buy that and you then do good marketing, all the money that comes in all drops to the bottom line and all goes in your pocket. So once you've purchased the property and you've got your mortgage payment, assuming the property can support the mortgage, everything you do beyond that that's profitable goes directly to you. It's like dangling a giant carrot and it's a huge motivator because everyone loves immediate gratification.
When you buy a storage facility on a 30 year note, you will not own it in full for 30 years. However, if you go out there and rent that extra unit or two, if you raise the rents up a little bit, all that goes directly into your pocket every day or every month when you collect the rents. So in that way, cash flow should always be looked upon as a motivating item. You want to make sure that you've got healthy coverage of your note payment, but after note payment, cash flow, that item, you need to look at that as something you're always trying to maximize selfishly, because you win in two directions. If you're able to increase the cash flow of the property substantially, it also increases the value.
And there's one item we didn't talk about yet, and that is what happens when you go to sell the storage facility at the end. Because if you have a three point spread and that gets you a 20% Cash-on-Cash return, that doesn't even account the profit of when you sell the property at the end of the movie. So when you sell it at the end of the movie, where does that money go? Well, that's profit. You have to take that money and basically divide through over how many years you owned it, to add that onto your total Cash-on-Cash return. So as you can see, self storage has an unusual angle because you buy it frozen in time at one rent level and amount of occupancy and amount of cost, and then your goal is to keep improving that thereafter, giving you an entirely different ending to the movie than what you initially anticipated.
And if you do a good job, if you use common sense, if you're a good buyer, if you do good due diligence and you make the right decision, then you have nothing but good news ahead, because you should be able to beat and outstrip your budgets every month, leading you to have far greater net income, far greater cashflow and excellent Cash-on-Cash return. And then when you sell it at the appropriate CAP rate, a large bounty of profit at the end, just by the act of owning the property. So, overall, you'll see those are the three key measurements of any self storage property and they're important measurements and they're also important that you always think about those when analyzing to decide whether to pull the trigger and buy the property or not.
This is Frank Rolfe, The Self Storage Investing Mastery podcast series. Talk to you again soon.