Investor interest in self-storage has skyrocketed during the last decade. This niche property's stable returns and growing demand are drawing attention from an array of new investors, particularly large institutions seeking to diversify their portfolios. These new players are increasing transaction volume at a record-setting pace: In a recent joint venture, Extra Space Storage and Prudential Real Estate Investors bought Storage USA's 458 facilities for $2.3 billion from GE Commercial Finance. This deal clearly demonstrates that the self-storage asset class has arrived.
Strong market fundamentals further support the sector's growing presence. The United States has approximately 44,000 self-storage facilities totaling 1.5 billion square feet with a market value of about $120 billion. Public ownership of self-storage currently hovers around 13 percent, which is higher than that of apartment, office, and warehouse sectors. Extra Space Storage of Salt Lake City and U-Store-It of Cleveland both completed public offerings last year, joining existing self-storage real estate investment trusts Public Storage, Shurgard Storage Centers, and Sovran Self Storage. Other companies quickly are following suit by acquiring and developing properties with the intention of forming new REITs. These companies are fueling a consolidation trend that slowly is changing the self-storage market landscape.
Emerging Industry Trends
Portfolio transactions are gaining more market attention. Self-storage operators weighing the possibility of a future public offering are bulking up their total assets to satisfy future public investors, while newly formed public companies continue to acquire stabilized properties that improve company earnings.
The Extra Space Storage transaction catapulted the company to the No. 2 U.S. self-storage operator slot. With 630 facilities totaling 43 million sf, it trails only industry leader Public Storage. Prior to going public, Extra Space strategically acquired Storage Spot's portfolio of 26 properties for $147 million. In addition, prior to its public offering, U-Store-It purchased National Self-Storage's 3.6 million-square-foot portfolio for $212 million and entered into a $184 million agreement for Metro Self-Storage's 42-facility portfolio. In the largest transaction proposed, Shurgard Storage Centers recently rejected an unsolicited $2.5 billion offer from Public Storage for the entire company. These deals highlight the market shifts toward consolidation.
However, despite the new public entities and large institutional players controlling a bigger part of the market, small owners and operators are still the majority. The largest owner/operator, Public Storage with 90 million sf and 1,480 facilities, controls only about 6 percent of the market. Combined, the top 10 companies only control about 16 percent of the total market.
Many small and mid-size operators are aligning with joint-venture partners using various investment strategies to take advantage of low interest rates for building and low capitalization rates for selling. For instance, Morgan Stanley Real Estate's Prime Property Fund recently established a $400 million joint venture with Safeguard Storage Properties, a private company in New Orleans with 56 facilities.
In addition, several developers have designated programs to acquire land or vacant buildings and build self-storage portfolios for immediate sale. The current liquidity in the market gives these merchant builders a stable source of potential purchasers. After returns on investment are paid, merchant builders take the remaining proceeds and reinvest in new development deals for future sale.
Another recent trend centers on builders that are selling non-stabilized properties with repositioning potential. Even some newly constructed facilities are attracting buyer interest prior to leasing. For example, Devon Self-Storage in Emeryville, Calif., has developed a systematic program to acquire and convert obsolete warehouses and recycled big-box stores into state-of-the-art self-storage facilities. Devon regularly partners with pension funds to develop and aggressively lease up the facilities. When the properties are near stabilized occupancies they are packaged together for sale.
Though the landscape continues to evolve, there are two distinctly different types of self-storage investors - institutional and private. Most institutional investors, such as opportunity funds, pension funds, and life insurance companies, require shorter investment terms and will consider higher risk projects with correspondingly higher yields than most private investors.
In addition, institutional investors typically are not interested in long-term joint ventures. Their objectives are to invest capital into a development and obtain a return on investment upon selling. Most institutional investors prefer three- to five-year terms, although recently some are considering individual fund terms of five to seven years.
Since some institutional investors are investing from commingled funds that have expiration dates, they must invest in shorter-term intervals. For example, an institution may require that it receives its initial investment back plus a minimum internal rate of return of 20 percent within three to five years. Most institutions also look at development opportunities because they more likely will generate their minimum IRR, often in the high teens to low 20 percent range.
In contrast, most private investors are high-net-worth individuals or private funds that frequently want to own properties long term, often for an indefinite time period. A private investor may be less likely to look at an IRR calculation to determine its interest in a specific self-storage development. Less interested in a rapid payback, most private investors seek returns on total cost in the range of 11 percent to 14 percent. Private investors often evaluate investment opportunities by calculating the project's IRR based on a fictitious sale in five years. The real test for many long-term private investors is to analyze the percentage of their original equity investment that will be returned upon a refinancing in two to four years.
In recent years, the capital markets have expressed confidence in self-storage through the diversity of financing options available. Owners seeking to purchase self-storage facilities may choose between fixed- and floating-rate loans; construction and bridge financing are readily available from local banks, credit companies, life insurance companies, and investment banks.
The proliferation of commercial mortgage-backed securities makes five- to 10-year loans a desirable financing option. These securitized loans typically feature low interest rates and high loan-to-value financing of 75 percent to 80 percent without a requirement for personal guarantees.
Abundant long-term financing is evident as current CMBS transaction volume is projected to exceed last year's $1.2 billion. Additionally, CMBS self-storage loans funded over the past 10 years have the lowest default rate of all property types at less than 1 percent, which compares favorably to the 4.5 percent average delinquency rate for all other property types. Standard & Poor's rating of $4 billion of CMBS loans secured by self-storage shows only five out of 1,102 loans are delinquent, with a .24 percent delinquency rate.
Risks to Consider
While the self-storage segment continues to prosper, capital can retreat from the market as swiftly as it entered. Self-storage risk characteristics are most similar to the multifamily sector. However, self-storage maintains a 150 to 200 basis point spread over apartment transactions. While capitalization rates for the entire self-storage sector averaged 8.5 percent to 9.0 percent last year, institutional-quality assets currently trade in the 6.75 percent to 7.5 percent range.
Negative news such as flat or falling rental rates or even defaults regarding one or more high-profile operators could affect investor sentiment toward the entire sector. A steady rise in interest rates likely will slow activity in highly leveraged transactions, as the spread narrows between current cash yields from self-storage properties and the cost of financing. Even a gradual improvement in rents would only partially offset higher interest rates.
Competition from new self-storage developments also limits investors' interest in purchasing existing facilities. Income generated from properties no longer directly relates to market values. Many markets previously believed to possess strong barriers to entry have lost this advantage. New facilities are getting approved in previously high-barrier markets with strict zoning regulations due, in large part, to the emerging sophistication in the aesthetics of new self-storage facilities.
The U.S. self-storage market has matured over the decade with more-professional facilities, greater industrywide information, and more-sophisticated market analyses. These factors and many others have contributed to a new wave of institutional investor interest in the sector. Yet despite the industry's recent growth spurt, small owners and operators still dominate the market, making it a highly fragmented but intriguing option for many investors.