Thinking about retiring? As the economy improves, REITs are making more and more acquisitions. With capitalization rates at the lowest we’ve seen in a long time, it might be a lucrative option for some self-storage operators to cash out and go along for the ride.
Preparing Your Property for a Sale
Before you contact the investment arm of a self-storage REIT, gather all of your documents: the trailing 12 months of financial statements, a unit-mix report, and any information on debt. Then ascertain what the going capitalization rates are for self-storage properties in your area and determine your desired sale price based on your estimated future cash flows.
Capitalization Rates
Self-storage properties are valued according to their ability to produce income, and buyers rely on a property’s capitalization rate to gauge the riskiness of a purchase.
Sale Price = Net Operating Income ÷ Capitalization Rate
In order to find net operating income, simply take gross income and subtract all normal operating expenses, excluding depreciation and loan payments. Normal operating expenses include insurance, property taxes, management fees, payroll, advertising, capital expenditures, and repairs.
For example, let’s say you operate a facility in Phoenix in a market where the current capitalization rates are around 7 percent; your gross income is $500,000, and your normal operating expenses are $150,000.
$500,000
($150,000)
$350,000
With your net operating income at $350,000 and capitalization rates at 7 percent, you should sell your facility for $5,000,000.
Sale Price = Net Operating Income ÷ Capitalization Rate
$5,000,000 = $350,000 ÷ .07
Alternatively, let’s say the SVP of Investments at a self-storage REIT underwrites your assets and offers you $4,200,000 for your property. If you know that capitalization rates are at 7 percent in your market, you will want to refuse this lowball offer, as this SVP is using a capitalization rate of 8.3 percent.
Capitalization Rate = Net Operating Income ÷ Sale Price
.083 = $350,000 ÷ $4,200,000
Capitalization rates are adjusted according to the perceived risks associated with your property. The higher the capitalization rate, the lower the perceived value of the property. Everything else being equal, a self-storage facility with strong financials, high occupancy levels, and a good location will warrant a lower capitalization rate. On the other hand, a facility with poor financials, low occupancy, and an undesirable location will receive a higher capitalization rate.
Benefits of Selling Property to a REIT
You defer capital gains tax and secure a steady income stream in the form of dividends.
When you sell a property to a REIT, you defer your capital gains tax. Unlike a 1031 exchange, however, you do not purchase another property in this case. Instead, you receive operating partnership units in a REIT, which can be converted into shares of stock at some point. By going this route, you secure a steady income stream as you collect dividends on these partnership units. Although you pay taxes on these dividends, you never pay taxes on your initial investment until you decide to convert your operating partnership units into stock. Generally, there will be at least a one-year lockup on these units, after which you can convert them into cash or REIT stock on a one-for-one basis.
Because you are getting a tax deferral, it is usually prudent to hold onto your partnership units for a long time. This is, of course, assuming that the REIT is performing well. If you sell your facility to one of the publicly traded storage REITs, the value of your partnership units will directly correlate with the movement of the REITs’ stock price. Likewise, if you sell your facility to a privately traded REIT, the value of your partnership units is dependent on the success of the REIT.
You can diversify your portfolio and plan your estate.
In addition to the potential liquidity benefits, a property sale to a REIT can also provide you with portfolio diversification and enormous tax benefits for your heirs. If you retain your partnership units until death, your estate can convert the units tax-free.
