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27 Mar 2019

3 Ways to Determine the Value of a Facility

author

Kate Spencer

Managing Director

A valuation of a self storage property can be necessary for a variety of scenarios: buying, selling, refinancing, estate planning or challenging the real estate assessment. Fortunately, the methodology for determining the property value is the same in all scenarios. When determining the value of a property, there are generally three approaches that are considered: Cost Approach, Sales Comparison Approach, and the Income Capitalization Approach.

Cost Approach

The Cost Approach is based on the premise that market participants relate value to cost. Appraisal concepts relating to this approach include substitution, supply and demand, contribution, externalities, and highest and best use.

In the Cost Approach, an opinion is formed of the cost of all improvements, depreciating them to reflect any value loss from physical, functional, and external causes. Land value, entrepreneurial incentive, and depreciated improvement costs are then added, resulting in an opinion of value for the subject property.

The downside of the Cost Approach is that the depreciation estimates used are highly subjective, which can limit the reliability of the approach. Additionally, land sales within the local area, while well researched, can be limited; therefore, in\ today’s market, the most important and common use of the cost approach is to determine the feasibility of a new or a recently constructed project.

Sales Comparison Approach

Using the Sales Comparison Approach, an opinion of market value is determined by analyzing similar, recently sold properties and comparing them to the subject property. This method relies on the concepts of anticipation and change, including the principles of supply and demand, substitution, balance, and externalities.

This approach typically uses a unit of comparison such as price per square foot of building area or effective gross income multiplier. Adjustments are applied to the unit of comparison from an analysis of comparable sales, and the adjusted unit of comparison is then used to derive an opinion of value for the subject property.

The Sales Comparison Approach is applicable when there is sufficient data on recent market transactions. In the case of the self storage industry, the Sales Comparison Approach provides good support but is not typically considered the primary value indicator, as self storage facilities are purchased for their income streams. Additionally, the comparable sales can vary widely in terms of physical and locational characteristics which are typically addressed through an adjustment process. Furthermore, it is better to select newer sales from a broader geographic area than older sales with the same geographic area in today’s market where capitalization rates have declined. In fact, capitalization rates derived from recent sales are the most useful data extracted from this approach for an investor.

Income Capitalization Approach

The Income Capitalization Approach first determines the income-producing capacity of a property by using contract rents on existing leases and by estimating market rent from rental activity at competing properties for the vacant space. Deductions are then made for vacancy and collection loss and operating expenses. The resulting net operating income is divided by an overall capitalization rate to derive an opinion of value for the subject property.

The capitalization rate represents the relationship between net operating income and value. This method is referred to as Direct Capitalization. A Discounted Cash Flow is also often utilized and this creates a multi-year cash flow projection with a reversion in the final year. A variety of assumptions can be made to test the sensitivity of the cash flow. Additionally, this method allows for any anticipated variances in the 10-year hold of the investment, such as capital expenditures and/or changes in expenses. In this method, periodic cash flows are discounted to a present value using a discount rate that is determined by analyzing current investor yield requirements for similar investments.

In today’s market, the Income Capitalization Approach is the most utilized method to determine the value of a self storage property. Future posts will detail how to build a proforma and ultimately determine the value of a self storage facility.

Originally published as part of the Self Storage Almanac.

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