After a period of low transaction activity, the market in the spring of 2011 showed signs of a steady, albeit moderate, recovery. Many of my current and potential clients were faced with deciding between selling and waiting to sell, in the hope that an increase in value would offset the delay. My crystal ball is no more accurate in predicting the future than is yours, but I do think we can look at some scenarios to create a framework within which to consider where values are headed.
To start, consider a self-storage property located in a mid-size market with good visibility. Let us assume it is a 50,000 square foot facility, 85 percent occupied, and market rents average $10/square foot per year. The revenue and income would look like this:
As we can see, this property has a value of $3,453,125 at a capitalization rate of eight percent. Now, let us assume a buyer would finance 75 percent of that value ($2,589,844) at six percent, with an amortization of over 25 years. The annual debt service would be $200,237. Subtracted from the Net Operating Income of $276,250, the cash flow (before tax) is $76,013. That represents a cash on cash return to the buyer of 8.81 percent (76,013/276,250). While 8.81 percent cash-oncash return may not be adequate for many buyers, we will assume it is the target rate for the purposes of this article.
For the sake of our crystal ball, let us now assume the very same situation but with a higher interest rate of seven percent. The annual debt service increases to $219,654 and the before tax cash flow falls to $56,596, representing a lower 6.56 percent cash on cash return. If the buyer has an 8.8 percent cash on cash return target what must the value of the property be to generate such a return with a seven percent interest rate? With the higher interest rate, the buyer will see more cash from the net operating income go to service the debt. Accordingly, the buyer cannot afford to pay a price equal to an eight percent capitalization rate. But how much higher must the cap rate go to achieve the same cash on cash return for the buyer? If we consider the same property valued using an 8.56 percent cap rate we find that a buyer will achieve the desired cash on cash return with a seven percent interest rate. But note the seller now has seen a decrease in value (sales price) of $225,905. Another way of looking at the situation is that the seller has just lost over $200,000 in value simply with a one point increase in interest rates. The import of this is that values may decrease if interest rates increase.
Not so fast, you may say, because rental rates or occupancy are also likely to improve as interest rates increase. Assuming all the operating expenses stay exactly the same (which is unlikely), the owner of our fictitious self-storage property would have to increase rents (income) by $19,337 to keep the value constant. Net operating income would increase correspondingly to $295,587 which represents an increase of seven percent.
If we assume a 417 unit property, with an average of 120 square feet per unit, the average rental rate increase for each
of the occupied units (354) would be $55 or $4.60 per month. In other words, the owner must increase rental rates an average of $55 per year per occupied unit, or seven percent, to stay at exactly the same value as before due to the increase in interest rates from 6 percent to seven percent.
Accordingly, when faced with the prospect of selling now versus selling in the future, an owner may wish to consider if interest rates will increase. He may then wish to consider if rental rate increases can be made at an adequate pace to offset the impact of rising interest rates.
Many owners choose to wait to sell their property because they anticipate a better market and higher values. But as this analysis shows, rental rates and/or occupancy increases must outpace interest rate increases if there is to be a net gain in value.
Ask yourself, if interest rates rise one percent per year can rental rates be increased seven percent or more per year to maintain or increase value?
Time Value Of Money
As a final thought, consider the time value of money. Assume that in year one an owner is in the situation as described initially with cap rates at eight percent and a value of $3,543,125. He can choose to sell or wait to sell, and increase rental rates to stay even with the higher interest rates.
As we have seen, if interest rates go from six percent to seven percent in two years and the operator is successful in growing rental rates on occupied units 3.5 percent per year in years two and three, for a total of seven percent, he will have maintained the property’s value. Assuming no debt on the property, the owner has delayed the sale for those years but has enjoyed the entire net operating income
property because they anticipate a better
market and higher values.
(including increases). He then sells at the same price in year three. At first blush one might think it is wise to delay the sale, raise rates, pocket the net operating income and sell later.
If we assume the time value of money is equal to a discount rate of five percent interest rate increases. Should we experience a rapid increase in
values are likely to decrease.
interest rates, it may be improbable that increases in and that a prudent investor could earn a five percent return in a safe investment, the sell now versus sell later scenario would look something like the chart at left. The sell later owner would enjoy the net operating income in years one through three, and receive the sale proceeds at the end of year three.
The sell now owner would receive the net operating income in year one plus the sale proceeds. He would then receive five percent on that amount (sales proceeds plus year one NOI) in years two and three, assuming he reinvested the return from year two.
As can be seen, the owner who sells in year one ends up better off by about
$130,000 than the owner who waits to sell. The increased rental rates during that period do nothing to increase the value of the facility but rather those increases merely maintain the value due to the one percent increase in interest rates. What is the take away from all this? If you believe interest rates will increase over time, values will decline unless income increases keep pace or outpace those income through gains in occupancy and rental rates will be able to offset the negative impact on value. In short, if interest rates increase rapidly, values are likely to decrease. Even if values stay constant in the face of rising interest rates, given the time value of money, an owner may be wiser selling sooner rather than later.