Transcription
Welcome to Self Storage Income. And today, we're going over the three stages of underwriting, what it tells you, and how to do it.
This is a very specific breakdown because all three parts are different, and you need to know all three to be successful in self storage or any other asset class. Underwriting specifically, what does it tell us? The three things that you need to know and how to do it. Meaning, should you buy that asset or not? What should you pay? And then, what should you expect, plan for, and execute on? These are three fundamental things that every single person needs answers to, but you underwrite them differently. Each one.
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So, here are the three things that underwriting should tell you. First of all, what should I buy? Second, what should I pay for it? And three, what should I plan on? What's the future look like? They're all different ways to underwrite.
Let's start with number one, the buying decision. One of the most common questions that I get asked is, "Is this a good deal or not?" I don't know. In order to know if you should buy that or not, basically, we are looking at the opportunity today. The spread of what that asset is doing, what it should be doing. That opportunity that is on that table, then really broken down, what is the difference between them and you? Is this achievable? What is, as we call it, the money on the table? Knowing that if what you're going to buy is a good deal, if it'll be profitable, if you can make money off of it.
A few examples: How are they operating that asset or that facility? Delinquency rates, marketing, service, the looks of the facility, etc. Are you buying a perfect facility at the top of the market where there's nowhere to go, so you have all the downside and put yourself in a dangerous position? Or is there a lot of opportunity that is measurable that you can take actions on today?
What should you pay? This is very different than what you should buy. The reason being is all of that other stuff, meaning what you can do, what opportunity is, should never be included in the price that you pay. When you pay for something, it is predicated on today's performance and the past. You are looking at the value. Why? Because value and price are not the same thing. What it's worth, what it's valued at, and what the price is, maybe very disconnected. In order to know the price that you are willing to pay, you have to be able to articulate and really understand the value of that asset. Also, just because someone else will pay another price, a higher or a lower price, doesn't necessarily mean you should. You have to underwrite that off of today, what's happening, and you have to figure out the price that is right for you.
And number three, planning. This is one of the hardest. The reason being is number three, unlike number one and two, takes into account the things that are out of your control way more. We are looking at the stability of that marketplace, both the demographics of the region, the economy, as well as the marketplace of the storage facility, the storage assets within that market. Is this market growing? Are prices rising? Are you catching a falling knife? Meaning you have opportunity and you can pay a good price for it, but in five years, that asset's going to be worth less. This is long-term thinking, right? We're talking about the future. We're looking at risks in the marketplace that may not be realized in that buying decision or the price that you were going to pay. You may have opportunities in the future that you can take advantage of that may not have to do with today or today's price, like future expansion opportunities. Maybe they have a large employer coming in, which will increase demand and push up rates. This is market-driven. That's the key with the planning stage, understanding the future, long-term vision of that asset in that marketplace, and what you will be needing to do for the ongoing future. You don't want to make a buying decision and pay a price, even if both of those things work out, to something that long-term has risk, will be devalued, and is out of your control.
But today, we are going over just the buying decision and the price that you will pay. These are very closely related, and these are the things that are in your control. So, we want to look at how you do these things. They're very different, but they are related. So today, we'll figure out if I should buy it or not, and what should I pay for that asset?
How do we understand that? The first thing that you need to realize, there are lots of complicated Excel sheets. Underwriting, and what they do is they take all three of these things and they mash them together. When you're starting out, especially when you're trying to buy your first asset or you're just trying to understand on that acquisition process, I don't like to have too complicated of a look. Basically, I want a snapshot that is very static that forces me to make decisions predicated on the now, not anything else. We've created this to be a snapshot to understand the buying decision and the value at that given moment, which includes our overall operations, revenue, expenses. We take into account then value and financing, and then our rate of returns. Both of these things, or all three of these things combined, tells us those two things: buying and what we should pay.
We have two scenarios. We have scenario A and scenario B. Scenario A is the facility not under your management, under the management that it is now, exactly what it is doing as far as operating income goes. We take individual units, we plot those individual units out. We take the number of units, the price per units that are given now. Once again, this is simplified, meaning that if we have this first unit, which is a four by eight, and there's 18 of them, we put that that price is $40. That's not actually how it works. Not all 18 units are almost ever priced the same at $40. You can build this out, and I may have all the different units that are available in the different prices. Once again, keeping this simple so we can show you.
Now, when we look at scenario B, we are going to be looking at different scenarios within this on where it should be. Now, this is the key. You have to remember, when we do underwriting, we are not predicated on things that we think or we even believe. When we're looking at this buy option, it is only on measurables. So, this scenario B here, we have to be able to measure the outcomes, and we have to be able to show that it's one of the things that we do when we're looking and doing feasibility for people's storage facilities to tell them what we think of the asset in the market. Follow the link below, you can see those services that we offer.
On this scenario B, we are taking into account currently what like-minded assets are getting in the market, and we're trying to understand if there's a spread. As you can see, with this first type of unit, the current owner's charging $40. In our scenario, we have not found any any units that are charging over $40. We may even be at the top of that. We keep that the same. We don't have a measurable. Now, we may be able to get that up, maybe there's a lot of units that are fully occupied, but as of now, we're keeping that the same.
Now, if you look at the next unit right here, $45. But in the marketplace, these are full, and they're $85. Okay? Or there may be some vacancy. This is where we include here, this line, which I call my probability funnel. This is a really important piece to keep you in check. You do not want to underwrite to make deals. What does that mean? A lot of people underwrite for what they want the outcome to be, and they do it subconsciously. I want to buy it, I'm going to make the underwriting show me how I can get to a buying decision. Very dangerous. Most people don't even know that they're doing it. They start justifying things, and they start doing things that maybe not even reality at all. That's why we measure probability. Means the probability that I believe we can achieve this rate. This is going to tell me and should really keep me in check, the likelihood of the outcomes that we want to be delivered.
Generally speaking, the probability funnel that we utilize, this is something that we do off really how we feel about the market. But it includes three different things: measurable prices in the market, includes vacancies, and like-minded assets. Meaning that if we see in the market, we have $85 is being achieved at this six by eight right here, we say that's known. But there may be vacancy in that market, and also that $85 in the market may be being achieved by an asset that's a little better quality. So we're saying, "Ah, it's possible, but maybe it's not likely." In those circumstances, when we have a 70%, we will come in and we will reduce this number. We're saying we're not gonna, you know, it may be possible, but we don't really know if we can. Let's find that. Let's adjust that down to like-minded assets that have really, really tight, tight occupancy. Like this, our eight by eights, they're getting $50. We look in the market, the market's selling them at $96. There's virtually no vacancy, and all of them are being achieved, even like-minded assets. That gives us a 95% probability rate for that number, and so on and so forth.
Remember how we view units? Everybody, units are products. Individual products. We are doing product-market fit. We're selling them on the open marketplace. We have to figure out what their value in the marketplace is, and that consists of quality, supply and demand, and the individuals that are buying that and what they're using it for.
Once we get to the bottom, we tally up our whole thing after adjusted. We have the current existing actual income. This is important. This has to be verified. All right, lots of times owners will give you a list of units and what they're currently charging. Like I mentioned, that doesn't mean all units are getting that price. In fact, lots of times they have delinquencies, and their economic rate versus their physical rate is different. We made a video on economic versus physical occupancy and what that means. Check that out here, because that is going to be a big piece for you to understand that part. You want to make sure that this is accurate. Then we have the difference over here. We have a total likelihood that we're going to achieve it. Then we add in our vacancy loss. We up our vacancy loss if we are increasing rates. We do it to more of a standard in the marketplace and something realistic. But anytime you're upping rates, I do increase vacancy. Now, when we look at the overall income after vacancy loss, we have our totals.
Now, we're going to move on to our expenses. I'm not going to spend a lot of time on here except for a few things. Existing expenses that the operator gives you. Just because they say that that expense is there or not there, doesn't mean that that is 100% accurate. You need to really dive into that facility because this expense is associated with this return. What does that mean? This expense has to be able to generate that return, and I shouldn't have to increase that expense whatsoever to get that return. That's what I'm paying for. Lots of times, owners will forget to mention things, especially on small facilities. We may have an owner that is at that facility every day, taking customers, doing work every day, all day, and then they don't include any, let's say, salaries or payments for an employee. And then you ask, "Okay, why is there no salary? Why aren't you paying for any work to be done at the facility?" And the owner will say, "Well, I do it all." That's awesome. So, you're going to work for me for free then? Usually they say no. Well, then if not, you have to work every day to achieve this number right here. So, if you're not working at that facility, you're not achieving that number. That means we have to include the cost for someone to be there to do that work. You need to go through these expenses and really understand them.
Repairs and maintenance, right? Repairs and maintenance is a very important one when it comes to the look of the facility. And what I mean by this is, there are some expenses that you will have that they won't. Now, your repairs and maintenance is only attributed to that, meaning the asset as it is, should be fully able to operate and work, and the repairs and maintenance should just get it to that figure. That's not taking in things that you want. If that facility doesn't have a gate, for example, and you say, "Well, I need to put $35,000 in expenses to get a gate," that's fine. But if they're operating without that, that is something that you want. And generally, owners aren't going to say, "We're going to up our repairs and maintenance a ton to do things that you want to change." Usually, when you change that's on you. But if we have doors that are broken, units that can't be rented out, if we have issues with the asset that would in any way prevent it performing this to do its job, that needs to be included.
You go down, we look at expenses. The only other one that I'm going to mention right now is this one: real estate taxes. I have seen so many people get burned by this. Everybody, and that is that the owner reports the real estate taxes that they are paying. That real estate tax that they are paying is predicated on what they bought it for or that value. When you buy that asset, you are going to change the value. Now, this is different in every state, in every county. You need to understand, is this a disclosure state? Is this a non-disclosure state? What is the county set up to handle tax increases? Is there a cap? Is there not? Does it adjust immediately? All of that, because this will change. You do not pay for an asset on their taxes. You pay for an asset and you include the taxes that you have to pay. Why? They're saying that that's the price. So, if that's the price, those taxes have to reflect that price, not theirs. That doesn't make any sense. A lot of people will not ask or will not change that, only to find out that their taxes doubled, and it took a huge portion of the profit away, and now the facility is worth immensely less, and they can't generate close to the profit that the owner was before.
All right, looking at net income. We take this when you buy. By the time that you make a decision, by the way, the probability funnel, everybody, for your overall expenses needs to be 90% or higher. Meaning that by the time you're there, you should know exactly the expenses you need. You should have quotes. You should understand exactly what it's going to take. If you have guesses, and if you're not sure on this, this can trap you. That is a very, very important piece, everyone. Okay? That is not something that we will allow for. Last, maybe like the revenue, to find achievable, that needs to be known.
Now, we have a big difference here, $63,000 to $111,000. Remember, everyone, this is an actual facility that we actually underwrote, and these are our actual numbers, and we are being conservative on this. All right? Now, we're moving on to expenditures. Cap rates. We're not going to dive in too much. We're using a cap rate to fix values. So, when we look at scenario A, this, everyone, tells us our price. Okay? So that's the price. Scenario B is what it could be doing, should be doing, and will be doing. Us, right? That is what I would say is more the value that we are going to create. That's our buy decision. So, we find out that the property value at that cap rate, right, is a million bucks. But under us, it's 1.8. Almost in this example, we have exactly an 80% increase in value. So that turns it from the 6 cap to an 11 cap. Now, we don't go, and the owner says, "You can achieve all of these things, so I'm going to charge 1.8." Well, you didn't do that. That doesn't exist. So, if I buy it, I have to pay you for what I'm going to do, and I don't even know that I can achieve it, right? And if I buy this, I need to know that I can have value, that I can increase it, that this will be a profitable venture. So, I want to come up with my my price tag, what it'll be under me, and give a strict timeframe to achieve that.
Loan information, everybody. We're not going to dive in too deep to that. That has more to do with overall returns, things you're looking that'll change all the time per property. You just got to get a quote and figure that out. And there's obviously no difference to its performance today and what you will be, because those two things are are different under that person, which you don't know what the owner's current situation is.
Now, when we're looking at it, the spread on our return. So, we've got value and price. What does that now mean to our overall return? As we found out, our cash-on-cash return, ROI, it's around 6% under what they're doing, and around 17.6 under what we believe we could do. If you are okay with this, and you believe that that is strong, achievable, and you're good with that, and you really believe that this is good, that's that's your buying decision. Then, okay, let's do it. I was already basically okay with this. I can live with this, but it has this great potential. This tells us our returns, whether those returns are justifiable at a price we want to pay for it, at how it's operating today, and what it should be doing. Once again, everyone, this is a snapshot only. This does not include future years of revenue growth or any of that kind of stuff. It is a straight-line snapshot that is measured, and we have something to tell us what is happening in the market and where that asset should be.
I hope you understand and see the purpose of these three different parts of underwriting, why they are different, how they are different, and what it tells us. Remember, we underwrite to understand if we should be buying it. We underwrite to see what we should pay. And we underwrite to plan for the future. Now, the planning for the future is a different type of modeling. We model out years, which looks at everything from demographics to a whole bunch of other stuff, which we do not have included in this video. We have videos that are predicated and solely dedicated to planning, meaning market studies. You can check them out here.
For the most part, this is the really, really, really important part. People generally aren't sure if they should pull the trigger and buy it or what they should pay for it. This is exactly how you walk through and do it, and it should be simple. What I mean by simple is, it should be very identifiable, and it should be able to be measured. When you go to a bank, when you go to investors, you should say, "This is what it's doing right now. This is what it's worth today. Its price is predicated on that to me X. This is what it'll be doing once I fix things or once I own it." Either way, even if there's not a change, but then you need to explain the difference between them owning the asset and you owning the asset, what it means, in exact steps to achieve it. If it's not measurable, if it's not simple, you are going to get into a very, very big gray area of guessing and infilling gaps in underwriting, justifying prices, and you do not want to be in that situation. The more complex you get, the more errors there can be.
This buying decision, I want it to be very clear. This is a good deal. This is something I want to buy, and I can see that it's very evident, and I can measure it. Pay is going to depend on what it's currently doing. And then the seller, there's two components to that. This, you may figure out as we did say, "Okay, I want to pay a million bucks." They may say, "I want 1.1 for it." Then the question is, should you go that high or what should you do there? That's negotiations, and that's going to be really predicated on what you believe the asset is doing and what that means at its current state. Make it simple, make it evident and measurable. That'll help you move quickly through deals that you shouldn't be buying, don't want to buy, and identifying ones that are buying acquisition targets. Then worry about the price and negotiate on the price, due diligence, and working on that asset in the market, really plan for the future operations, executing on this opportunity, and looking forward.
I hope this makes sense, everybody. I hope it helps. You want to know more about this or even see our underwriting sheet? Follow this link right here so you can start underwriting deals in this way and looking at the snapshot. With that, everybody, see you next time.