The net operating income is effective gross income less the expenses. This calculation is the key figure to determine when valuing a property. The resulting net operating income is divided by an overall capitalization rate to derive an opinion of value for the subject property.
The following is a summary of the various components that are needed to create a pro forma:
- Actual Rent
- Vacant Units at Market
- Other Sources of Income
- Vacancy & Collection Loss
- Effective Gross Income
- Net Operating Income
A capitalization rate is a rate-of-return on a real estate investment based on the net operating income.
Capitalization rates are fluid and take into consideration many different variables with regard to the real estate investment, as well as the state of the market at the time of the analysis.
It is important to know that properties can change at any time, and the identification of that rate is at that particular point in time.
As it relates to the subject property, variables can be the quality and condition of the property, location, tenancy, and historical operations. Externally, variables include the current market conditions, interest rates, and surrounding and potential competition.
All of these factors play a role in the ultimate net operating income of the property; however, they are also considered when applying the rate to determine the value of a property.
There are a myriad of ways to obtain current capitalization rate information, but it is important to acquire the most up-to-date information as the market continues to change.
The following three methods are the most common:
- Recent Comparable Sales
- Investor Surveys
- Market Participant Interviews
- Discounted Cash Flow
In today’s market, self storage participants are increasingly sophisticated; therefore, a Discounted Cash Flow analysis is often utilized by investors. This involves a forecast of cash flows over a typical holding period (usually 10 years) and requires assumptions regarding income and expense growth rates. Because most investors separate the actual income collected from the vacant units at market rents, different growth rates can be utilized.
In today’s market, investors are typically forecasting slightly lower growth rates (from 5% to 8% to 3% to 5%) than in the recent past due to the influx of new supply in most trade areas.
With that, aggressive revenue enhancement techniques allow managers and owners to analyze the income at the facility. Additionally, owners and managers know that rental rates can be increased on an existing tenant at a higher growth rate due to them being a “captive” tenant. Most often, it takes significant effort to move out of a facility; therefore, owners and management have become proficient in finding the sweet spot between raising rents and losing tenants. The sensitivity of each facility is highly dependent on the local area and is unique to each location.