Have you ever looked at an offering memorandum and become confused by the industry jargon around cap rates, cash-on-cash returns, and price-per-foot comparisons? Sometimes, the more you try to understand, the more confused you become. In this two-part article, I’m going to cover the primary ways real estate investors value deals and compare returns.
Replacement cost is the amount it would cost to replace (rebuild) a facility using today’s materials at today’s prices. In other words, how much would it cost to build a new facility like the one we’re evaluating? To find the answer, an estimate of the construction cost per square foot is typically used.
For example, a target facility has 50,000 gross square feet, is single story with all climate-controlled units. The estimated cost of construction of a similar facility is $70 per square foot (PSF). The replacement cost would be 50,000 x $75 = $3,750,000.
Using that math, one might conclude the self-storage facility is worth $3,750,000, but this would be incorrect. Why? Because this calculation doesn’t tell us anything about the cash that the 50,000 square foot facility generates. Two facilities that are next door to each other, similar in style and features, could cost the same to build but would vary in their market value based on the rents, the expenses, and the financing options. Replacement cost does not consider any of those financial aspects that investors are concerned with, such as investment value.
If you have ever bought or sold a home, it’s likely you sat through a real estate agent’s presentation of their opinion of the sale price of your home. Part of that presentation probably included a discussion of the comparable sales and adjustments for things like the number of bedrooms, bathrooms, or other finishes compared to your home. The result is the estimated range of the sale price of your home. This can be an awkward conversation depending on their opinion versus your opinion!
In some self-storage offering memorandums, we will see sales comparisons used by self-storage brokers to help justify the price the seller is asking. The glaring omission is the multiple adjustments that would need to be made to make the sales comparisons like the target storage facility. Can you imagine making price adjustments for the number of units, climate versus non-climate, office spaces, number of keypads and gates, fencing? The list goes on!
Here’s what you need to know: the sales comparison approach to value is typically used for single-family homes and other property types that don’t generate income, not for self-storage facilities that are income-producing.
Most importantly, the sale comparison approach ignores income, expenses, and financing terms. In other words, this approach to valuation doesn’t concern itself with what investors are concerned with: investment value.
Price Per Square Foot
This is a metric derived from the sale comparison approach to valuation and is very easy to calculate. If a 50,000 square foot facility sold for $6 million, we would divide the sale price by the square feet: $6,000,000/50,000 sq. ft. = $120 per square foot (PSF). In other words, the facility sold for $120 PSF. Unless we have another number to compare that to, we don’t know much other than the answer to a division problem!
A few weeks ago, two facilities sold in Naples, Florida: one for $107 PSF and the other for $182 PSF. That’s a huge difference in price per square foot, but that doesn’t mean the first buyer got a deal and the second buyer overpaid.
Those facilities were in different submarkets, with different demographics, and different levels of storage supply. The first one was built in 2000, the second was built in 2021. The first one averaged $1.25 PSF for rent, the second over $2.00 PSF! Once we dig a little deeper, we can see why there was a big difference in the price per square foot.
The demographics and financial outlook matter much more than the PSF. Just like the sales comparison approach, the PSF metric is interesting and something we calculate when underwriting deals, but it doesn’t consider investment value.
I hope you found these explanations helpful. Next month, in part two, I’ll cover the internal rate of return, equity multiple, the compound annual growth rate, the capitalization rate, and cash-on-cash.