How to Value a Self-Storage Facility - Don't Overpay!

Dec 08, 2023

Storage is a truly unique concept, and in this video, we'll delve into the fundamental aspects of value. It's crucial to distinguish that price and value are not synonymous; we'll illustrate this point using examples from one of my facilities. I'll take you through the specific numbers that determine both the price and the value.

Intrinsic vs. Extrinsic Value

To comprehend the essence of value, we must recognize that there are two facets we need to build upon in determining what is a reasonable payment. These are intrinsic and extrinsic value. Intrinsic value pertains to the actual revenue generated, while extrinsic value is simply the price. However, in the current market landscape, there seems to be a shift where the traditional roles of extrinsic and intrinsic value have reversed. Transactions have sharply declined, resembling levels not seen since 2008-2010. 

Perspectives on Value: Owners vs. Investors

The disparity in perspectives arises because owners focus on intrinsic value, while investors prioritize extrinsic value. Owners argue that the asset's price remains unchanged because the revenue hasn't fluctuated. In contrast, investors contend that the asset's value has decreased, citing a drop from 4 million to 3 million.

In storage and other commercial assets, valuation typically relies on specific metrics, with cap rates being a widely accepted indicator. In its simplest form, a cap rate expresses the return on investment. For instance, if a million-dollar investment yields $100,000, it represents a 10 cap or a 10% return. Conversely, if the investment is $2 million for the same $100,000 return, it's a five cap, indicating a lower return. Essentially, the lower the cap rate, the higher the price, and vice versa—the cap rate inversely correlates with the return on investment.

Significance of Cap Rates in Asset Valuation 

The significance of cap rates lies in their exclusion of factors such as the cost of money or debt. While intrinsic value remains constant, extrinsic value undergoes changes, and these alterations in extrinsic value are influenced by market dynamics rather than the intrinsic characteristics of the asset. This lack of direct correlation between intrinsic and extrinsic value creates a spread between buyers and sellers, causing a market freeze.

As a value investor, I find opportunities during periods when extrinsic value experiences volatility. This situation allows me to acquire assets with solid intrinsic value at a lower cost. It's crucial to safeguard against market fluctuations in extrinsic value, as these fluctuations are influenced by external market forces beyond one's control. When extrinsic value is high, there's increased buying and selling activity, leading to a spike in market volume—a potential sign of a bubble.

Navigating Low Extrinsic Value Markets

Conversely, when extrinsic value is low, the market experiences a decrease in volume as numerous sellers are motivated to sell. This scenario poses challenges, such as seller-financed deals and brand-new properties selling below replacement cost, which are uncommon occurrences. Despite the difficulties, the perseverance pays off in such unsettled markets. However, it's important to note that the benefits of this hard work may not materialize immediately.

Strategies for Intrinsic Value Dynamics

To effectively navigate the dynamics of intrinsic value, our approach involves measuring, planning, and executing strategies. Intrinsic value holds paramount importance, as it dictates the ability to service debt, meet financial obligations, and fundamentally transforms the landscape of an asset, influencing its potential and risks. The inputs that drive revenue are key, presenting opportunities that lie in understanding and managing these factors.

Now, let's delve into the practical aspects by examining the numbers. Assume an equal baseline scenario with a deal structure of 30% down at $750,000. In this context, intrinsic value is represented by income, while extrinsic value is denoted by the cap rate.

In comparing two periods, where income fluctuates while the cap rate remains constant, we observe a direct correlation. A decrease in income from $100,000 to $50,000 results in a -111% change, while an increase from $100,000 to $150,000 yields a positive 111% change. This correlation is intuitive when income is the variable.

However, when market dynamics change, represented by variations in the cap rate while keeping income constant, the impact is not symmetrical. For instance, a shift from a 6-cap to an 8-cap signifies a decrease in prices (as cap rates go up), resulting in a -55% change. Conversely, if the market becomes more favorable with a change from a 6-cap to a 4-cap, indicating increased buyer interest and higher prices, the change is +111%.

What's noteworthy is that the effects of cap rate changes on the market are not proportionate, unlike the consistent impact observed with income changes. This analysis underscores the intricate relationship between intrinsic and extrinsic value and emphasizes the need to carefully evaluate these factors. While the numbers may seem complex, this understanding is crucial for making informed decisions in the dynamic landscape of asset valuation.

Exploring Dynamics: Income and Market Conditions Interplay

The intriguing dynamics emerge when we explore the interplay of income and market conditions. Consider a scenario where income decreases from $100,000 to $50,000 over the course of a year, reflecting the same income change as in the first example. However, the market sentiment is positive, leading to a decrease in the cap rate from 6 to 4. In this case, despite the income decline, the strong demand for assets results in someone being willing to pay more. Consequently, the cap rate goes from 6 to 4, a 55% increase. This stands in contrast to the previous example where, with income going up, the same cap rate change led to a more substantial 111% increase.

Conversely, let's explore a scenario where income increases while the market experiences a downturn. If income goes up by the same amount it decreased in the previous example, and the market goes down by the same percentage, we observe a positive 27% change. This highlights a crucial point: the increase in intrinsic value, represented by income, is a more potent determinant of success.

You can observe market fluctuations and shifts in overall market demand, which undoubtedly exert a substantial influence. However, their impact is not nearly as profound as that of income— in fact, it almost entirely offsets it. This concept forms the core of our entire investment thesis and strategy. Our fund is designed to engage in value-based investing, emphasizing opportunistic approaches to capitalize on disparities and spreads in the marketplace. 

Intrinsic Value as a Hedging Strategy

To underscore the significance of these factors, we've structured our entire approach around intrinsic value. This is the linchpin of our strategy, serving as a hedge against market downturns and fluctuating rates, providing a level of control. Our focus is on intrinsic income, a measurable and known spread that serves as a buffer against market uncertainties. By aligning ourselves strategically, we aim to ride the wave of extrinsic value, capitalizing on markets influenced by institutional money and rising values.

For instance, when intrinsic income increases by $50,000 and prices or cap rates follow suit, the correlation results in a 277% increase. Conversely, a simultaneous decrease in both factors at the same rate leads to a 138% decrease, akin to financial distress. The net spread between these scenarios is a significant 416%, encapsulating the essence of our investing thesis. Over nearly two decades, our focus has been on identifying measurable and known income spreads and positioning ourselves accordingly.

Understanding this foundational approach, we can now delve into a practical example—my facility. The crucial aspect to grasp is the emphasis on controllables. How does this all fit together, and what actions can you take to hedge against market changes? We navigate the market's unpredictability while actively building intrinsic value to extract. 

Although market dynamics contribute to demand and income rates, our strategy doesn't project these factors into the future. Instead, we focus on the two elements we can control, ensuring a robust and reliable foundation for our investment approach. I trust that these examples illuminate my perspective on intrinsic and extrinsic values and the intricate relationship between the two.

Strategic Asset Acquisition: Unlocking Value Through Unique Opportunities

Now, let's delve into a concrete asset with specific numbers to illustrate what this approach looks like. We acquired a highly unique asset that was previously owned by the state, which went up for auction. Initially, we were skeptical about our chances of purchasing it, expecting others to recognize its value. This significant property is strategically located at a major freeway exit in a high-density, rapidly growing market for multifamily units.

The initial appraisal valued the asset at $3 million, but upon closer inspection, we identified fundamental flaws in this assessment. Our own analysis factored in market rates, revenue per square foot, and the facility's historical lack of rent increases over a decade. Additionally, poor management and high delinquencies were contributing factors. To provide a more accurate valuation, we approached our bank and requested an appraisal based on the true market dynamics.

We closed the deal at $4.8 million, almost $2 million higher than the initial appraisal. It's worth noting that competitive bidding ceased at $4.5 million, with only U-Haul willing to go beyond. However, they pulled out at $3 million, deeming it too costly. What set us apart was our meticulous valuation beyond the $3 million benchmark, leading to our appraisal indicating a value of $7 million—a further testament to our focus on intrinsic value.

Cash Flow Success: Strategic Approach and Impressive Returns

In terms of cash flow, our strategic approach paid off. In the first year, we generated $77,000, doubling it to $150,000 by the second year and reaching nearly $300,000 by the sixth year. This impressive cash flow translated to a cumulative return of almost $2 million by year six, with our overall cash-on-cash return exceeding 80%. We accomplished this solely by concentrating on the identified spread and measuring cash flows.

Although we haven't sold the property, choosing instead to refinance, the fair market value conservatively surpassed $8.8 million by year six. This equated to an astounding 425% return on revenue basis. Our strategic approach allowed us to realize high returns, reaching nearly $5 million and providing insights that others failed to recognize.

That's the essence of intrinsic and extrinsic value. If this asset had been sold or bought under normal circumstances, its sales value would have been significantly higher. However, the simple appraisal and the figure assigned to it skewed the market. This scenario serves as a prime example of the Price versus Value dynamic we emphasize. The value we perceived had a $2 million difference from the valuation held by almost everyone else—indicating a misalignment in understanding.

Market Cycles and Risk Mitigation: Safeguarding Against Disparities

In market cycles, such disparities can be risky, especially when refinancing or selling is necessary. A difference in value between $3 million and $5 million can pose a challenge, potentially leading to financial difficulties. We've witnessed this phenomenon during shifts in cap rates and interest rates, where perceived value, influenced by external factors, deviates from intrinsic value.

To safeguard against these Market Cycles, we adopt a strategy of locking in our debt and commitment to selling for a decade. This approach allows us the flexibility to refinance or sell strategically, mitigating the impact of market fluctuations. Our goal is to avoid being dependent on external factors and instead focus on intrinsic improvements, increasing revenue flows over time.

In 2008, we recognized it as an opportune time to buy because the market was undervaluing income significantly. During such periods, when market sentiment puts a low valuation on the same income, there's a unique chance to capitalize. When considering this income line that's currently undervalued, the potential for it to rise becomes the focus. This strategy involves planning and measuring based on income, seizing the advantage presented by market fluctuations.

The key to our approach lies in concentrating on the present—on the income that is tangible and can be measured today. It's not about speculating on future cap rates or income but understanding the current difference between income and value. In the example of the facility we acquired, the spread we evaluated wasn't based on speculative future market changes. It was grounded in the present—considering delinquencies, current market conditions, and what the market could realistically achieve today.

This difference between income and value is measurable and known, forming the crux of our strategy. We encourage you to adopt a similar perspective when evaluating Value. Identify, on every project, whether it aligns more with intrinsic or extrinsic factors. Determine where these two aspects converge or separate, as that's where valuable opportunities lie.

We invite you to share your observations in the comments. Are you currently witnessing a separation between income and value? Have you come across any noteworthy deals? We're eager to hear about it. Make sure to subscribe, like, and share your insights. 

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