Why Capitalization (cap) Rate Is BS When Selling Your Facility

Ok, maybe the title is a bit aggressive. But stay with me here - if you are in love with capitalization rate (from here on out “cap-rate”), maybe it's time you expand your horizons a bit - it could save you thousands.

Of note, this post is written from the sellers standpoint but the information applies to everyone.

Let's start with the basics. What is the cap-rate?

By pure definition:

Cap-rate = NOI / Purchase Price

Simply put it reflects the relation between net operating income (NOI) and how much the property is worth. Assuming you are trying to sell your facility, we can change “purchase price” to “sale price”.

And switch things around a little bit.

NOI = Cap-rate * Sale Price

Put another way:

Sale price = NOI / Cap-rate

All three of these formulas are the EXACT same formula - just with the variables moved around. And remember, you can change ALL THREE VARIABLES.

But they don’t just change magically. You can’t simply “decrease the cap-rate”. (remember a lower cap-rate means a higher sales price)

I find this final iteration the most useful as a potential self storage seller. Why? Well, let’s dissect a bit.

Obviously, the sale price is important to you. At the end of the day, it's the main thing you care about.

But does the cap-rate REALLY determine the sales price?

An Extreme(ly Illustrative) Example

Let’s take an extreme example to illustrate a point:

You own one of the very few self storage facilities in Northern Alaska. You are doing well until your facility gets hit by a freak hurricane - a once in a million year event!

The hurricane destroys 95/100 of your doors.

You decide not to replace those doors, losing 95/100 customers.

Your revenue takes a huge hit. You previously had a NOI of $100k/year (a good NOI in Northern Alaska if you ask me) but with your occupancy issues you end up with an NOI of only $5k.

You decide to sell.

So you look up average cap-rates for self storage in your area. You look at comparable self storage facilities in your area and see what they sold for. It turns out, cap-rates in Northern Alaska are around 8% AKA “an 8 cap”.

(Of note, I know literally nothing about self storage in Northern Alaska, this is just an example. Do they even have storage there? I’m on a plane with no wifi, look it up yourself if you really need to know.)

Sorry, back to the example.

You want to know what your facility is worth.

Let’s do the numbers.

Sale price = NOI / Cap-rate

Inserting your Cap-rate and NOI:

SALES PRICE = $5,000 / 0.08 (aka 8%)

That makes your SALES PRICE = $62,000!

That's TERRIBLE!

Something doesn’t make sense. You have a 100 unit facility that simply needs some new doors. It’s clearly worth more that ~$62k. (Even if your facility is in North Alaska!).

So what is a “fair price” for your facility?

Well let’s look at it from a more reasonable standpoint.

Before the damage and decrease in NOI your NOI was $100k/year.

We already noted that comparable facilities sold at an 8 cap.

So before the drop in occupancy your facility was worth:

Sale price = NOI / Cap-rate

Inserting your Cap-rate and PRIOR NOI:

SALES PRICE = $100,000 / 0.08 (aka 8%)

Making your SALES PRICE = $1,250,000 

That’s much better!

So can you actually get a buyer for the $1.25M?

Well, let’s bring the example to its logical conclusion:

Your buyer looks at that facility and says: “I know it CAN be worth $1.25M, but this facility needs new doors - that’s going to cost me $100k. AND I have to lease up the facility - that will take 2 years which will effectively cost me $100k. AND there is some possibly unforeseen risk with the deal - I want to hedge the risk with a $100k decrease in price.”

The buyer agrees to purchase your facility for $925k.

You agree and gladly sell your damaged, low-occupancy facility for $925k.

Everyone is happy!

You sell your facility for a good amount.

And the buyer gets a facility that will soon be worth $1.25M - for $925k!

So what cap-rate did you get?

Cap-rate = NOI / Purchase Price

Inserting your current numbers:

Cap-rate = $5k / $925k

Cap-rate = 0.5%

A 0.5 Cap!

Amazing for you!

But ask any buyer if they would buy a facility at a 0.5 cap.

A 0.5 Cap is effectively unheard of.

A totally unreasonable cap-rate!

Nobody would actually do it.

But then again, deal was fair.

Here we see the flaw of looking at cap-rate alone. Clearly the deal is reasonable. Sure, you could argue the $925k up or down a bit but overall the $925k is reasonable price. The cap-rate, using the current NOI is simply not a useful way of looking at the deal.

Of course, one solution is to calculate the cap-rate based on the projected future NOI. And that is quite a reasonable thing to do. It’s effectively what we did when discussing the “fair” price for this example facility.

Obviously, most deals won’t be THIS extreme. But buyers will take into consideration occupancy/repairs etc. when determining a purchase price for your facility.

So what is the best way to use cap-rate?

It’s a tool like any other.

It’s not a magic oracle that “determines” the sales price. Instead, cap-rate is simply a relation between sales price and NOI.

Sometimes it doesn’t make sense to rely on cap-rate rate alone.

However, for stable facilities it can be a useful tool to predict valuation.

Instead of looking at cap-rate alone. Try to understand your facility as a whole:

• Does it have expansion potential?

• Is there a huge upside that your potential buyer can capitalize on by increasing operational efficiency?

• Is it in a location that is clearly growing (or declining)?

• Does your facility need repairs to get it to market value?

• Is there a huge demand still left in your area or is your area saturated?

• Does your facility have automation/procedures/workflows in place that will make things easier for the buyerBy pure definition:e way to increase your NOI? Or can you explain to your seller why they will be able to increase thek

Think about these questions AND think about the mindset of the buyer.

While you may be able to sell your facility for a large amount, most buyers are savvy and don’t want to risk theirs (and potentially other people’s) money on a far too expensive facility.

Instead think about what would YOU would be willing to pay for your facility. Not necessarily what you “want” for your facility.

Maybe you want too much.

Or worse - maybe you are asking too little!

Come to the right number of what YOU would be willing to pay (maybe add a little bit to it!) and you will end up to selling your facility for the right price and in a reasonable amount of time.