This post is an abbreviated version of an article that originally was published in Argus’ Market Monitor newsletter.
Now is not the time to ignore operating expenses.
Over the past 10 years, I’ve realized that complacency is a major problem in self-storage, particularly since we’ve been enjoying the recent strong performance of the industry. At one time or another, we have all looked at our to-do list and thought, “I can do that next month.”
Reviewing your operating expenses, however, is not one of those things you can afford to put off till next month. Operating expenses need to be reviewed regularly to ensure that the value of your property and its cash flow are not being undermined by subtle, yet devastating, increases in your operating expenses.
Approaching the peak?
With all-time high capital flows of both equity and debt into the self-storage industry, it has continued to gain respect from Wall Street and the greater real estate investment world. This capital flow has caused capitalization rates to compress to record lows. It is because of this, along with low interest rates and strong market fundamentals, that the values of self-storage properties have soared and made some owners complacent.
When values climb and cap rates compress, we must ask ourselves: What happens when the market peaks? And how can we protect our investment?
The risk that self-storage owners face today is not only whether their net operating income goes up or down, but whether cap rates go up faster than their net operating income (NOI) can compensate for the loss of value.
With investors looking to maximize their rate of return and limit the amount of risk, it is only logical to think that if owners control operating expenses and increase revenue, the NOI and cash flow will boost the value of the asset.
Understanding the magnitude of what each dollar of NOI means to the value of an asset is the first step toward protecting and preserving value.
Work the numbers
Let’s take a self-storage property with annual gross revenue of $400,000 and annual operating expenses of $150,000. This property then would have an NOI of $250,000, which would be capitalized at a reasonable cap rate by an investor/owner to arrive at a value. With today’s cap rates in the 6 percent to 8 percent range, this property’s value would be $3,125,000 to $4,166,000.
Reducing the operating expenses by 10 percent, or $15,000 a year, would lift the value by $187,000 to $250,000. This means that for every dollar you reduce your operating expenses, thus increasing NOI, you would expect to receive $12 to $16 in value.
With the majority of self-storage operating expenses fixed in three or four categories, it’s easy to see how yearly contract increases, gas surcharges and administrative fees can quickly deteriorate the value of an asset.
It’s worth noting that you don’t have to sell your property to get the benefit of reduced operating expenses. The value will be reflected in the amount that you can borrow on the property and a rise in monthly cash flow. Generally speaking, you can expect to borrow 65 percent to 75 percent of the increase in value when you refinance.
In today’s ultra-competitive storage investment market, rethinking the way you approach your operating expenses and instituting a process of regularly reviewing those expenses will keep both your vendors and your expenses in line.
Self-storage continues to be the darling of real estate investment and has earned its way into the core real estate sector, with higher returns and lower losses than asset types. But that doesn’t mean you can overlook your operating expenses.
Self-storage values are at or near an all-time high, and owners must be diligent about reviewing and controlling their operating expenses if self-storage is to remain the shining star of the real estate investment world.
Infographic via getonthesinside.com