And now for the rest of the story…

And now for the rest of the story…

By Jane H. Sauls, CCIM & Luke Sauls

The storage industry has been fast and furious for over four years. Owners and investors tal growth in markets nationwide. According to Green Street dex, valuations peaked early 2022 with an increase of 66% compared to pre-covid numbers. For perspective, Greenstreet reported all property asset classes increased by an average of 14%. So once again self storage comes through like a knight in shining armor. Secondary and tertiary markets became as popular as the primary markets attracting attention from the largest of operators, as many families returned to more rural settings to live, work remotely, and play. The continuous buzz in the industry was the historically low cap rates, making cap rates the golden child and to some the only child.

A cap rate is the ratio between purchase price and net operating income. In other words, by converting income to value, a cap rate expresses the relationship between one year’s income and value. (CCIM Glossary)

In theory, cap rates allow investors to make apple -to- apple comparisons of assets by only considering the twelve months of revenue and expenses that would remain a part of the operating business when the property is sold. For example, depreciation and interest expenses are not deducted in the NOI calculation because that is subject to the new owner. However, the reality is that cap rates do not take into account if the facility is at market rental rates, the current (or future) management platform, new improvements, if there is deferred maintenance or land to expand. Cap rates are a snapshot of the investment and not a true testament to how hard your money will work or is working.

Cap rates are often times the focus of attention because they are easy back of napkin calculations. They have dangerously become the center of attention to unseasoned investors and owners. Basically, the cap rate is a single page in the book and you need to read the entire book before making an investment decision. The internal rate of return is the entire story from beginning to end. It’s everything that you put into the property and everything that you get out of the property, including the income each year plus the sales proceeds.

The Internal Rate of Return (IRR) is the percentage rate earned on each dollar that remains in an investment each year. The IRR of an investment is the discount rate at which the sum of the present value of future cash flows equals the initial capital investment. (CCIM Glossary)

In today’s changing economic cycle, now more than ever you must underwrite the entire property and its market to best position yourself to achieve your short and long-term goals. As self storage owners the known monthly cash flow is one of our greatest assets, but you have to have a much longer term approach when you are in the commercial real estate market. By doing so your focus shifts to the internal rate of return.

The IRR considers what you will do with the property, in terms of management style, marketing preferences, rental rate increases, ancillary income and even your exit strategy. IRR calculations empower the investor to compare cash on cash returns with leveraged returns. As the cost of debt increases, this analysis is more critical than ever. The Cash-on-Cash IRR can be compared to various leverage options to best match your investment needs.

What’s important today is that we strategize well to last long enough to enjoy the happily ever after. In other words, you must be able to pay your bills every month to stay in the game. The bank’s go-to tool is the debt coverage ratio. Most lenders prefer 1.2 or more depending on the financial depth of the investor.

Debt-coverage ratio (DCR) Ratio of net operating income to annual debt service.

Expressed as net operating income divided by annual debt service. (CCIM Glossary)

Here’s the ratio in plain terms: The “1” Indicates that you have enough money after expenses to pay your mortgage payments. The numbers following the decimal reflect how much breathing room you have after paying your expenses and debt. The higher the DCR the more comfort the lenders have of your project pulling through changing times.

As you can see buying solely on cap rate is about as smart as marrying someone just for their looks...you better get to know the property before you buy it. Creating a successful plan demands a team of experts working with you to achieve your goals. Be sure to develop relationships with a broker, banker and CPA that align with your investment goals. You must understand the current valuation and what impacts the future value of that property. Be sure to know your numbers and work with a team that understands your return expectations. Strategize to maximize your cash flows and your valuation will benefit! Have a plan but be ready to Pounce, Pause or Pivot.