I recently hosted a webinar on self-storage investing where the attendees could ask me anything. Two questions came up that are pertinent to the types of deals we look for and our view on inflation and interest rates. 

What factors have the greatest impact on facility value?

Two things can have the most significant impact on value: the net operating income (NOI) and location. Both will be reflected in the cap rate. Let me explain.

A cap rate is the NOI divided by the price. It tells you what your all-cash return would be and can be used to compare returns of properties. 

If you can increase your NOI, you will increase the price buyers are willing to pay.

For example, suppose properties in a particular market are selling at a six percent cap, and the NOI at facility A is $300,000. In that case, buyers will be willing to pay $5 million for that facility. At location B, if NOI is $400,000 and the cap rate is six percent, buyers will pay $6.7 million for that facility.

How does the location play a role in creating value?

If facility B is in a market where cap rates are five percent instead of six percent, investors would be willing to pay $8 million for that facility instead of $6.7 million.

Why would investors pay more? Because they see the market risk as less of a factor in the 5-cap market.

Maybe there is a diverse economy and more job and population growth. Investors will pay more for reduced market risk.

Which poses a larger risk for investors: Inflation or Rising Interest Rates?

The bigger risk for investors is interest rates. Picture it like this: Interest rates are the cost of borrowing money. If they go up, it becomes more expensive to get the money you need to buy a property.

This can mess up your plans. Here’s how:

Let’s say you sign a contract to buy a property in December, thinking you’ll get a loan with a certain interest rate.

By the time you complete your loan documents and are ready to lock in your rate, the rate has gone up, causing your equity returns to go down.

The only way to increase the equity returns is to reduce the purchase price. Most sellers aren’t going to be happy to have that conversation. A lot of deals fell apart in 2023 because of this exact scenario.

Now, imagine you’re raising capital for a fund. You want to complete ten deals to close out the fund. If interest rates are stable, you won’t run into price adjustment problems. 

But if rates are rising rapidly, as they did in 2022 and 2023, you won’t be able to close at the same price as you went under contract on, and the returns on your last deal could be worse than the returns on your first deal when rates were stable.

Simply put, it’s like playing a game where the rules can change while you’re still playing. This is why rising interest rates pose greater risks for investors, especially if they are raising a fund.

So, why do interest rates go up or down? If there is an increase in demand for money, they go up. If there is a decrease in demand for money, they go down.

Various factors cause the rise or fall in credit demand, inflation being one of them.

We’ve covered two questions I’ve received from investors on impacts to value. I hope you better understand how we view value, markets, and interest rates when we underwrite self-storage deals.

If you enjoyed this article or have follow-up questions, please reach out to me at kris@passiveinvesting.com.