In a published article by Royce Rowles of PGP Valuation Inc, Royce discusses the ratio between annual net income and sales prices.

“While the NOI may be falling at many properties (due to increased vacancy rates and/or more competitive rental rates), it almost certainly does not account for the entire value decline in this market. Major value declines also come from the changing status quo between buyers and sellers. Buyers have become much more patient and are expecting a much more favorable ratio between their NOI and purchase price. In other words, when there are fewer buyers (as often is the case in a down market) capitalization rates move upward. In situations where there are recent comparable sales, anyone valuing a property can easily extract and apply very current and realistic capitalization rates to estimate Market Value. This is because during times of appreciation, the market is usually active. Extracting supportable capitalization rates is easy. However, when transactions are scarce finding market capitalization rates can be significantly harder. When this happens, oftentimes sellers have an unrealistic opinion of value because they are relying on dated capitalization rate sources.”

So how do you extract capitalization rates, when transactions have been scarce? The following page discusses five ways to analyze capitalization rates.

National Surveys

According to the 2^nd Quarter 2009 National Investor Survey prepared by Korpacz, capitalization rates for self-storage facilities range from 7.00% to 10.00% with an average of 8.55%. Korpacz is just one of several national surveys providing important perspective relating to overall trends in the market. It’s important to not place too much emphasis on national surveys as there may be wide fluctuations in regional and local markets. However, a national survey is an important starting point to get an overall perspective of what capitalization rates are doing on a national level.

Existing Sales

In analyzing existing sales over the last couple of years, the older the transaction dates the superior the marketing conditions. In almost all cases, this outweighs some of the less important qualitative adjustments such as quality, condition, and age. As appraisers, it is more important to select more current sales outside the market than older sales within the market area.

Capitalization rates for self storage facilities have increased 100 to 150 basis points over the last 12-18 months, with typical capitalization rates ranging from 8.0% to 10%. Transactions sub 8.0% are hard to find in this economy. It seems like the days for buying a property based on a ”Pro Forma” is gone. Buyers will only look at current in place income and expenses, since this is how lenders are underwriting properties. Here is what we are see regarding capitalization rates in this market:

• Good quality / good location (8.0% – 8.5%)
• Average quality / average location (8.75% – 9.5%)
• Fair quality / poor or saturated location (10% – 12%)

Band of Investment Technique

Because most properties are purchased with debt and equity capital, the overall capitalization rate must satisfy the market return requirements of both investment positions. Lenders must anticipate receiving a competitive interest rate commensurate with the perceived risk of the investment or they will not make funds available. Lenders also require that the principal amount of the loan be repaid through period amortization payments. Similarly, equity investors must anticipate receiving a competitive equity cash return commensurate with the perceived risk or they will invest their funds elsewhere.

Effective Gross Income Multiplier Method (EGIM)

This multiplier is used as an indicator of value and takes into consideration the proportion of expense to every dollar of effective gross income. It is derived by dividing the sale price by the Effective Gross Income. Typically, effective gross income multipliers, which are derived and applied before considering expenses, are used without adjustments. The expected trend is as expense ratios increase multipliers decrease. It is common to put weight on those comparables with similar expense ratios (% of Effective gross income). The following table is a sample.

Broker/Listing

Brokers’ perspective are very important, as they have a pulse of what is going on in the area. Appraisers typically quote brokers in their reports, as well as provide several listings. Below is a sample of self storage listings currently on the market throughout the country.

Accurate valuation is enhanced by solid operating history. However, it is common to rely upon expense comparable data when valuing properties through direct capitalization. Understanding how operating expenses vary from region-to-region is key, especially for specialized lenders and investors looking to expand into other national markets. The table to the right is a sampling of over 200 expense comparables located throughout the country (evenly distributed). In addition, we have added information from the most recent Self Storage Almanac. Possible considerations for comparing operating expenses are discussed below.

Real Estate Taxes: Every state has its own method for calculating property taxes. There are several states (like Michigan and California) that reassess facilities based on sales price. Therefore, since the definition of “Market Value” assumes a sale, appraisers are forced to use an amount calculating the value of the property and the tax rate. Each local jurisdiction must be reviewed and understood. This can oftentimes cause headaches for refinances and construction loans.

Insurance: Rates are fairly similar across the nation. Special consideration should be given to flood, earthquake, hurricane, or other natural disaster areas. Typical range for this category is $0.15 to $0.25/SF. It is typical for lower rates to be achieved through blanket policies. It will be interesting to see if or how much policies rise over the next couple years due to a variety of factors.

Utilities: Both location and climate play a role in this category. Densely populated areas typically see higher energy costs. The number of climate controlled units at a facility should also be considered. Typical range for this category is $0.15 to $0.40/SF.

Repairs and Maintenance: This category includes cleaning out the units, replacing doors, landscaping and any maintenance associated with the facility. Areas that require a snow removal expense and/or elevator servicing are typically higher. Long term expenditures are also affected by climate; however, these expenses are typically covered in the reserves category. Typical range for this category is $0.15 to $0.30/SF. Age and physical characteristics play a part in budgeting for this category.

Off-Site Management: This is typically done on a percentage basis (EGI). Therefore, areas with higher rents result in higher management costs. Typical costs range from 4% to 6% of Effective Gross Income. This expense is not to be confused with General/Administrative expenses.

On-Site Management: This category is greatly impacted by location and average living expenses. Unless zoning restricts, it is common for resident managers to live on-site. Expenses are often higher for facilities not offering living accommodations for managers. Typical range for this category is $0.75 to $1.25/SF.

Advertisement: The amount of competing facilities and the property’s access and exposure are primary considerations for this category. Typical range for this category is $0.20 to $.40/SF.

General/Administrative: Fairly comparable from region-to-region. This expense includes accounting, legal fees, other professional fees, and general administrative costs. Typical range for this category is $0.25 to $.40/SF.

Reserves: This category takes into consideration capital improvements over a holding period. For self-storage facilities, it would typically include replacing the roofs, resurfacing the streets, and replacing the fencing and storage doors. Typical range for this category is $0.10 to $.20/SF.

Now that the effects of the credit crisis have become more fully evident while continuing to grip our economy, 2009 has revealed a repositioning within the real estate markets. Commercial real estate values are returning to the core fundamentals that always drove the market prior to the rise of Commercial Mortgage Backed Securities (CMBS). The availability of easy, non-recourse money and the flood of investors transitioning away from Wall Street in the late 1990s led to an unprecedented spike in demand, which caused a dramatic increase in prices and a loosening of investment standards. The results have been painfully evident.

The last couple of years have represented a time in which markets stagnated, not solely due to the lack of available capital, but also due to the gap in expectations between buyers and sellers. Sellers clung to memories of historically low capitalization rates and aggressive rent projections, while buyers assumed the worst in their cash flow analysis and disregarded cap rates altogether. The chasm between buyers and sellers over the last couple of years has widened to the point of stunting almost all activity in the market. The result of the stagnation is that market values are relatively vague across most property types. However, in the self storage industry, this separation of value between buyers/sellers is not as pronounced as other property types. However, due to the lack of capital, capitalization rates for self storage facilities have increased 100 to 150 basis points over the last 12-18 months, with typical rates ranging from 8.0% to 10%. Transactions sub 8.0% are hard to find in this economy.

Most industry experts concur – the commercial real estate market trails residential and is affected by all of the additional external influences that affect the economy as a whole. When combined with the still-compounding effects of stock market fluctuations, increasing unemployment rates, decreased consumer spending (although some moderate, recent gains), and ongoing corporate restructuring and downsizing, conditions are likely to worsen in the near future. As just one more reminder, key markets such as New York are just beginning to feel the impacts of financial sector lay-offs with commercial space inventories dramatically increasing and residential foreclosures accelerating. These key markets set trends across other areas of the nation. In addition, one should be mindful still of the $3 trillion of commercial market debt coming due with no real sense of how this will be absorbed. Negative impacts could be substantial without a plan and available capital.

In addition, as financial institutions continue to flounder or be seized by the FDIC, related asset workouts are the growing trends. In the past, the FDIC would typically take over one bank in a time span covering years. In 2009, the FDIC has seized over 100 banks to date and the number is anticipated to rise rapidly. Sitting on the books of these failed financial institutions are portfolios of properties that must be immediately appraised for true, current value and factored against the current market conditions in order to dispose of the assets. While perhaps not directly deepening our economic crisis, this will most likely extend the overall recovery cycle with commercial real estate looking at another 5-7 year window for more healthy conditions.

With all of these factors in play, expect market participants in the future to be more realistic in their internal underwriting, but to place emphasis on initial cash-on-cash returns and a flight to quality. Well-located, good quality product will slowly begin to move again as the expectations between buyers and sellers move toward each other.

Jeffrey R. Shouse, PGP Valuation Inc

Self Storage Director

Jeffrey R. Shouse joined PGP Valuation Inc in January 1998. He is working toward receiving his MAI designation. His primary focus is on the valuation of mobile home parks, self-storage facilities, and multi-family developments. Over the last several years, Jeff has appraised these property types in over 40 states.His clients include lenders, developers, owners, attorneys, insurance companies, and redevelopment groups.

Jeff was raised in Sacramento, California. After high school graduation, he attended Utah Valley State College where he received an Associate Degree. He then attended Brigham Young University and California State University, Sacramento, receiving a Bachelor Degree. Jeff is currently the Senior Managing Director for the Sacramento, San Francisco, Irvine, and Denver offices. He oversees the largest team at PGP Valuation with 17 total employees.

Jeff’s responsibility within the firm is to oversee the Business Development Group. Jeff enjoys sports and his family is a high priority in his life (married – four kids). He currently serves as a Community Affairs Director for his church. He has traveled extensively throughout Europe and speaks Estonian.

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Despite a slightly rally on April 6th, equity REITs posted a 32% decline in the 1st quarter (FTSE NAREIT Equity Index). In March, REITs we up about 4%.

Shopping center and Industrial REITs were the worst performing sectors, each declining about 41% in the quarter. Manufactured Housing was the best performing sector, declining just 2%. Manufactured Housing is viewed as a more “recession proof” sector, which could benefit as people trade down to less expensive rentals.

We expect continued volatility in REITs over the next couple of months due to commercial real estate fundamentals, which are falling in most property types. If you jump into the sector, make sure you are diversified and only buy companies that have enough liquidity to roll over 2009 debt.

Going forward, our favorite sector in 2009 is Apartments and our least favorite is Office. Apartment owners will benefit due to a growing pool of potential renters and lower turnover. Office landlords are struggling due to the lack of corporate expansion; many companies are reluctant to take on new space until the economy improves.

Office vacancies are increasing in most regions in the U.S. Among our buys are apartment REITs, Equity Residential (EQR) and Mid-America Apartments (MAA), two REITs with minimal 2009 debt maturities and attractive valuations. 

1.) Market Intelligently – Are you maximizing your marketing dollar?Are you thinking outside the box? A variety of marketing tools exist intoday’s self-storage industry. In addition to traditional media types such as print ads and yellow page listings, an effective website can beessential to capturing today’s savvy consumer. Approximately 80% ofyour tenants will come from a certain demographic and are comingfrom a select few marketing programs. Know your demographic!Some great ideas can be found in Ken Brown’s great article in theFebruary 2009 SSA Globe Magazine.

2.) Don’t Give it Away for Free – Are concessions hurting or helpingyou? Concessions are a powerful tool to attract tenants. However, becareful not to advertise blanket specials. Instead, concessions shouldbe strategically targeted to increase income by discounting specific unittypes that have historically low occupancy levels. This will not onlyincrease the productivity of those unit types with higher vacancies, butwill also sustain the economic productivity of unit types heavilydemanded by the market.

3.) Leverage Zoning – Are you aware of the extra value hidden in theland beneath your facility? Knowing the zoning code that governs yourparcel can open up opportunities to create substantial income streamsthat are steady, dependable, and low-maintenance in nature. Potentialways to leverage your zoning include RV storage, cellular tower’s,billboard leasing and a host of other creative ideas.

4.) Maximize Unit Efficiency – Is the layout of your facility negativelyaffecting your income generating potential? Maximize the productivityof your property. Remember that overall income trends upward as unitsizes decrease in most markets. To the degree that the market willabsorb them, partition unnecessary large units into unit sizes that rentat a higher price per SF to recapture lost potential income. Again, knowyour demographics! Ending up with too many 5×5 units will result in lowoccupancy and unsatisfied income expectations. 

5.) Image is Everything – What first impression does your facility give to potential customers? The best tenants will be looking for high-quality, attractive facilities. Simple practices such as a fresh coat of paint, pressure washing doors and exteriors, picking up trash, and sweeping out units are all affordable ways that please those payingattention to detail. A few flowers and nice landscaping will also add greatly to your facility’s curb appeal.

6.) Put Your Best Face Forward – Who is the face of your facility? Your choice of staff will be the face of your business. Managers who can give a good impression to potential tenants with charisma and attentiveness as well as capture your vision of professional service will attract and retain your tenants. Capitalize on the great supply of talent swimming in the current job market.

7.) Track Your Performance – Do you know exactly what your facility’s weakness is? Do you know how potential customers are being received by your staff? By keeping detailed records on a per unit basis you can address individual supply and demand issues. By keeping track ofyour customer service and tenant flow you can notice trends that may help you capture more business. In both instances, tracking your performance can help you chart your path to increased value.

8.) Know Your Neighbors – Do you participate in your community? All things being equal, the vendor that establishes more relationships within the community and becomes known for its services will always generate the most business. Get involved with businesses and residents, and you will gain a more intimate knowledge of your market area, which will allow you to customize yourself to their needs.

9.) Utilize Security – Do tenants know your facility is safe? Reliable and visible security features will attract high quality tenants and lend to the credibility of the facility. Video surveillance, electronic gates, fencing, individual unit alarms, and on-site management are all becoming standards in the self storage community.

10.) Storage Income Is Not Everything – How much ancillary income does your facility produce? The most successful operators in this industry have recognized that income is not limited to the monthly rent of their units. Additional income generators include RV/boat storage, specialized wine storage, safe deposit boxes, and a host of other creative ideas. Also, look at miscellaneous income items which could include administration fees, late fees, merchandise sales, truck rental, video conference rooms, and auctioning services.

Like most other income property classes, with the exception of apartments, financing for self-storage properties has been hard hit with limited capital available in today’s market. Because of the management intensive nature of self-storage, lenders including banks and insurance companies who once were willing to fund loans on this property type have either taken self storage off their lending list or have tightened up underwriting parameters by decreasing loan to value ratios and increasing debt service coverage requirements. In general, underwriting Cap rates exceed 8.50%, loan to value ratios cap out at 60% and debt service coverage requires a minimum 1.30x. Only well located, seasoned and stabilized properties with sound management qualify for and have access to the lowest priced capital which in today’s market comes from a small group of insurance company lenders. Ten year fixed rates, in general start at 7.50% with the only nonrecourse money coming from insurance company lenders. 

These rates were driven down by equally historically low interest rates spurned by the Federal Reserve Bank’s lowering of the Fed Rate to help jumpstart theeconomy after the 9/11 terrorist attacks and earlier downturn in the dot.com market. While the lower rates did promote more debt by consumers and madehousing more affordable, the subsequent housing boom was not built on solid economic drivers (job gains, increase in exports, etc.) and the run-up in housingprices was not supported. The hastily prepared, adjustable rate loans were bundled together and sold on Wall Street, incorrectly rated and sold to uninformedinvestors. The US economy, that was held up primarily by the housing market (mortgage companies, lenders, developers, home-builders, contractors, etc. allexperienced substantial growth over this period) became very unstable when supply exceeded demand and home prices began to fall. Concurrently, theadjustable rate loans began to see large rate increases that the unqualified buyers were unable to keep pace with. As housing prices declined, borrowers wereunable to refinance their loans resulting in defaults. The loans sold on Wall Street were spiraling in value and almost overnight, investors in the large conduitloans stopped buying the paper. Lenders that were not prepared to carry and service the massive amounts of residential and commercial paper were nowburdened with loans that had no buyers at rates that were too low to sustain.

The mounting loans that were going into default coupled with the growing uncertainty surrounding the economic outlook and crashes in the global economycaused many banks to stop lending altogether. In late 2008, the Federal Government again interceded to create TARP, a $700 billion dollar bail-out for many ofthese lenders that had created the market instability, fearing that these companies collapse would spark further economic decline through job losses, lower retailsales and a further decline in housing prices. The government’s primary concern was the lending environment had seized up after Wall Street stopped buyingpaper. The uncertainty on the part of lenders continues today with some lenders quoting 600 to 2,000 basis points over the historically low Treasury rates fornew loans, with only the most qualified buyers and the safest of loans being written. At the same time, loan to value ratios decreased from 90% to 100% down to50% to 60%.

As a result, only well capitalized buyers even qualify for a loan in the current environment. While sellers have been reticent to sell, since few buyers are evenless credit are available for deals priced below 7.0%, qualified buyers have realized that they now control the market and many also fear the uncertaintysurrounding pricing. Investors have reported equity return requirements near 12% with limited risk to venture from the sidelines. Consequently, a stalematebetween buyers and sellers has taken hold of the commercial real estate market. The standoff will likely continue until sellers, some that have already lost up to 20% in book value on their investments, need to either refinance their existing loans or cannot afford the new payments as rates adjust upwards and, in eitherevent, are forced to sell.

In a published article by Royce Rowles of PGP Valuation Inc, Royce discusses the ratio between annual net income and sales prices.

“While the NOI may be falling at many properties (due to increased vacancy rates and/or more competitive rental rates), it almost certainly does notaccount for the entire value decline in this market. Major value declines also come from the changing status quo between buyers and sellers. Buyershave become much more patient and are expecting a much more favorable ratio between their NOI and purchase price. In other words, when thereare fewer buyers (as often is the case in a down market) capitalization rates move upward. In situations where there are recent comparable sales,anyone valuing a property can easily extract and apply very current and realistic capitalization rates to estimate Market Value. This is because duringtimes of appreciation, the market is usually active. Extracting supportable capitalization rates is easy. However, when transactions are scarce findingmarket capitalization rates can be significantly harder. When this happens, oftentimes sellers have an unrealistic opinion of value because they arerelying on dated capitalization rate sources.”

The following is a sample of recent self-storage sales collected from across the United States by PGP Valuation. 

Real Estate Taxes: Every state has its own method for calculating propertytaxes. There are several states (like Michigan and California) that reassessfacilities based on sales price. Therefore, since the definition of “MarketValue” assumes a sale, appraisers are forced to use an amount calculatingthe value of the property and the tax rate. Each local jurisdiction must bereviewed and understood. This can oftentimes cause headaches forrefinances and construction loans.

Insurance: Rates are fairly similar across the nation. Special considerationshould be given to flood, earthquake, hurricane, or other natural disasterareas. Typical range for this category is $0.15 to $0.25/SF. It is typical forlower rates to be achieved through blanket policies. It will be interesting tosee if or how much policies rise over the next couple years due to a variety offactors.

Utilities: Both location and climate play a role in this category. Denselypopulated areas typically see higher energy costs. The number of climatecontrolled units at a facility should also be considered. Typical range for thiscategory is $0.15 to $0.40/SF.

Repairs and Maintenance: This category includes cleaning out the units,replacing doors, landscaping and any maintenance associated with thefacility. Areas that require a snow removal expense and/or elevator servicingare typically higher. Long term expenditures are also affected by climate;however, these expenses are typically covered in the reserves category.Typical range for this category is $0.15 to $0.30/SF. Age and physicalcharacteristics play a part in budgeting for this category.

Off-Site Management: This is typically done on a percentage basis (EGI).Therefore, areas with higher rents result in higher management costs. Typicalcosts range from 4% to 6% of Effective Gross Income. This expense is not tobe confused with General/Administrative expenses.

On-Site Management: This category is greatly impacted by location andaverage living expenses. Unless zoning restricts, it is common for residentmanagers to live on-site. Expenses are often higher for facilities not offeringliving accommodations for managers. Typical range for this category is $0.75to $1.25/SF.

Advertisement: The amount of competing facilities and the property’s accessand exposure are primary considerations for this category. Typical range forthis category is $0.20 to $.40/SF.

General/Administrative: Fairly comparable from region-to-region. Thisexpense includes accounting, legal fees, other professional fees, and generaladministrative costs. Typical range for this category is $0.25 to $.40/SF.

Reserves: This category takes into consideration capital improvements overa holding period. For self-storage facilities, it would typically include replacingthe roofs, resurfacing the streets, and replacing the fencing and storagedoors. Typical range for this category is $0.10 to $.20/SF. 

• At year-end 1984 there were 6,601 facilities with 289.7 million square feet of rentable self-storage in the U.S. At year-end 2008, there were 51,250 “primary” selfstoragefacilities representing 2.35 billion square feet. This represents an increase of more than 2.0 billion square feet.

• The top 5 self-storage companies, including the four public companies (Public Storage, Extra Space,Sovran and U-Store-It – Real Estate Investment Trusts) plus U-Haul (a public company/non-REIT), own and operate some 4,630 self-storage facilities, or9.0% of all primary facilities. 

• An important subset of the last fact: there are some 27,650 small business entrepreneurs (90% of all self-storage companies) who own and operate just one “primary” self-storage facility.

• More than 700,000 self-storage units nation wide are rented to military personnel (4% of all units); however, in communities adjacent to US military bases, military occupancy can range from 20%-95% of all rented units.

• Nationally, at year-end 2008 primary self-storage facilities employed approximately 160,000 persons, or an average of 3.1 employees per facility

• During the peak development years (2004/05) approximately 8,700 new self-storage facilities, or480 million square feet of space were added.

• Gross square footage of self-storage “per capita” inthe US (at the state level) ranges from 1.60 to 18.65square feet 83.9 percent of all US counties (or2,634 out of 3,141) have at least one “primary” selfstorage facility