The Basics of a Transactional Self Storage Market – The Dichotomy of Cap Rates and Interest Rates

The self storage industry is a unique and resilient sector of commercial real estate, historically benefiting from consistent demand fueled by urbanization, downsizing, generational shifts (mobilization) and technological advances supporting work from home jobs (Covid). These factors have driven up property values and, in turn, reduced cap rates. Historically, self storage trends have been cyclical. The historical high performance during Covid started the disruption in this cycle and the readjustment of the transactional market has taken longer during this cycle.

That said there has always been a dynamic interaction between sellers’ asking price cap rates and buyers’ financing interest rates. Think of it like a game of tug-o-war…except for a transactional market to optimally function, the tension on the rope should have the red flag somewhere in the middle. For this analogy, let’s call this a functioning transactional market (deals are getting done). Today’s self storage market in the game of tug-o-war, results in the tension being so great on both sides that the rope becomes weak and snaps in half (a disrupted transactional market).

Let’s look at the dichotomy between cap rates and interest rates by going back to the basics.

Cap Rates: The Sellers’ Perspective

A capitalization rate (cap rate) is the expected return on investment for a property. The cap rate calculation is simple; it is the net operating income (NOI) divided by the seller’ asking price. A seller aims to sell at a lower cap rate. A lower cap rate represents a higher value for the sellers’ property. A lower cap rate usually suggests a strong, desirable market with lower perceived risk (think higher rental rates, higher occupancy and a strong macroeconomic environment). On the other hand, higher cap rates may suggest higher risk or less demand with potentially a weaker macroeconomic environment.

Interest Rates: The Buyers’ Perspective

The buyers are significantly influenced by the interest rates at which they can get financing for the purchase of a self storage facility. These interest rates determine the cost of borrowing, which flows directly down to the overall return on investment. When interest rates are low, the cost of borrowing is low and in this environment the demand and number of buyers competing for buying properties increases thereby driving up prices and compressing cap rates.

When interest rates rise, the opposite occurs; the cost of borrowing increases, the buyer pool decreases, and their purchasing power also decreases. Buyers tend to get more conservative with their underwriting requiring higher returns to balance out the math. This causes downward pressure on property values and in theory, sellers should adjust their pricing expectations.

The Dichotomy in Today’s Market

Based upon the basics detailed above, cap rate increases should follow interest rates increase.? However, in the market we are in today, cap rates are not increasing at the same pace as interest rates. This is causing a standoff where transactions slow down as the market readjusts (an imbalance in the market).

For sellers in this market that need to sell (debt maturity, family events, partnership events, etc.), it is essential to understand the impact of interest rates on the buyers’ purchasing power. Another variable that is often widely overlooked by sellers is the impact of uncontrollable expenses the buyers face upon the acquisition of a self storage facility. The biggest example is property taxes. Sellers should underwrite their property’s value based upon their current NOI; however, I highly recommend sellers also underwrite their property based upon how a buyer sees the property value with market interest rates and an increase in property taxes determined by how local municipalities reassess commercial properties. The delta between values will not be favorable to the seller, but it is reality!

For buyers, it is critical that their financial modeling and due diligence are extremely thorough, including an accurate estimation of the property taxes moving forward. Also, an in-depth understanding of the self storage rates in the properties sub-market is critical.? Self-storage rental rates are such an important concept to understand, I will post an article later this week specifically on this topic. Perform a sensitivity analysis on the deal and know where the deal begins not make sense based upon the buyers underwriting thresholds looking at and adjusting many variables (purchase price, interest rates, financing terms (seller vs traditional), storage rental rates, occupancy (physical and economic), property taxes, etc.). If a buyer is obtaining a loan, pay close attention to the Debt Service Coverage Ratio (DSCR) and maintain consistent communication with your lender while underwriting, during due diligence and through closing.

Conclusion

It is imperative that Sellers know what the market value of their property is in today’s market. Be realistic! If a seller does not have to sell and their pricing expectations are based on 2021 values, consider NOT selling. If a seller does NEED to sell their property, I’ll say this again, BE REALISTIC on the estimation of value (Asking Price). I’ll say this again as well…Sellers need to know the delta between their valuation and what a buyer is ABLE to pay. A seller may also want to consider attractive seller financing. If the terms are attractive enough, buyers may even be willing to offer a higher purchase price. Listing a property with a broker is a great idea! I would highly recommend not going with the broker that says they will get you a value based upon 2021 valuations.

For a Buyer, be very diligent in your underwriting, and keep up to date with the market as you move through the transaction.

If you are a self storage owner and are curious about what the true value of your property is from a buyer’s perspective, I am happy to underwrite your property and give you my estimation of that value.