As self-storage continues to prosper and grow in value we are often asked the question: "when will values ’top out’?" Now that many people have had some experience with the stock market they have become a little more cautious. The quick answer to the question is, of course, as long as there is increasing cash flow there will be increasing value. However, there is a caveat to this good news and it is called replacement cost. Many savvy investors are sharply focused on this important benchmark when buying properties. They will either not buy a project or will really understand the circumstances when the selling price exceeds the replacement cost by a significant margin. I thought it might be worth taking a little time to explore the impact of replacement costs. But first let us look at the way value is determined.

Traditionally, as appraisers determine market value of a property, they look at three different ways to arrive at the value number. Theoretically, each of these methods should produce approximately the same value, thus providing a way to confirm and check the appraisers valuation. If the various methods do not reconcile the appraiser or buyer knows that he has a problem and that something is out of whack ( a technical term ) .

The three ways that appraisers look at value are:

1: The Income Approach: This method essentially values the cash flow produced by the property. The cash flow from the property is usually adjusted to be consistent with appraisal standard formats and the resulting adjusted cash flow is either divided by a Capitalization Rate ( Cap Rate ) or discounted over a period of time to arrive at a value. In most Self Storage transactions the income approach method using Cap Rates forms the basis for the transaction value. Typically the Cap Rates will range from 9.5 ( for gold standard properties ) to as high as 12 for marginal properties. Most transactions take place in the 10 to 11 Cap Rate range. Go to www.selfstorage.com, click on ARGUS and the Self Storage Articles button to find a good article on Cap Rates.

2: The Market Approach: This method of valuation looks at similar projects and extrapolates the prices at which they have been sold in the past to the property being appraised. While in theory this method will produce the same value, in practice it is quite difficult to use because minor differences in location, competition and physical characteristics can make the direct comparison of facilities difficult. Despite these facts, the Market Approach is a good check to verify the Income Approach.

3: The Cost Approach: The cost approach estimates what it would cost to duplicate the project, i.e. replacement cost. Appraisers actually don’t consider full replacement costs when looking at value because they may make estimates of several different kinds of adjustments such as depreciation and obsolescence. However, the unadjusted replacement cost number can give you a perspective on your own property value or on the value of a property that you maybe thinking of investing in.

Now that we know the different methods of estimating values let us explore how this can be used to evaluate not only the property but some strategic options as well. I have included in the chart some assumptions about a hypothetical facility that may make our explanation simpler.

While the numbers are somewhat simplistic they do raise some interesting questions that both owners and buyer should take into consideration when thinking about their investments. The issue is when replacement costs are substantially less than the cost to purchase or the value of existing facilities developers become highly motivated to build new facilities. The clear fact is that an experienced self storage developer would find this hypothetical situation quite interesting. Thus, unless there is something unique about the existing property or the local politics

(zoning) the owner should be expecting some future development in the area. Another dimension to our little calculation is that the new developer could rent his facility at rates about 20% less and make the same return on investment as the existing owner.

In this situation the existing owner should probably consider one of several courses of action, because if he doesn’t, he will very likely have a strong competitor quite soon. Some possible strategies available to the owner might be:

1: Expand the Existing Facility: If there is additional land available for expansion enlarging the facility can improve both the investment returns and cash flow. As an additional bonus, the new cash flow from the expansion comes without the burden of much of an increase in operating expenses. Expanding a facility can also discourage developers from starting new competing projects. Often times lenders will survey the area and find an expansion taking place, become more cautious and not finance another project.

2: Sell the Facility: Replacement costs do not always define an upper limit of value. However, in the absence of significant limitations on entry into the market

(zoning restrictions or lack of land) replacement costs will have the effect of holding down values in anticipation of future competition. Once the new competition commences construction it is too late to obtain the maximum value out of the property because a potential buyer will either assume the worst case scenario or simply will not proceed with the transaction. Thus, to take advantage of this favorable disparity in the market place an owner must be proactive in selling and not wait to react to the reality of competition.

There is a rule of thumb in the business that developers will become very serious about new developments when the spread of market value exceeds replacement cost by about 20%. This, of course, is not as true in times of high interest rates, tight money, or difficult economic times when developers as not active. But even in these types of situations the potential problem of the difference between replacement cost and market value remains, it is just deferred because of the economic circumstances.

You can see that it is important for owners and buyers to do a careful analysis of the impact of replacement costs on their continuing investment strategies.