Niche properties

The Self-Storage Transformation

Once Overlooked, This Specialty Property Now Is Packed With Opportunities.

Self-storage has evolved from the homely stepsister to the Cinderella of the commercial real estate industry. Once relegated to sites unsuitable for other productive uses and stigmatized as unsightly metal buildings, self-storage properties historically haven't attracted sophisticated investors' attention. Yet in recent years, the segment's solid performance and stable returns have piqued the interest of a growing number of investors.

Today's self-storage building designs are more aesthetically pleasing and the facilities' demographic locations mirror those of popular retail properties. Lower capital requirements and operating costs combined with demand growth have contributed to higher investment returns than many other property types. Self-storage's stable income stream provides durability unmatched by many other forms of real estate today. In addition, its steady performance not only has gained Wall Street's attention, but also that of other savvy, seasoned real estate investors looking for viable investment vehicles.

Although overbuilding is a problem in certain markets, particularly on the West Coast, self-storage has maintained good occupancies, even during economic downturns. Average occupancy levels currently range from about 84 percent to 90 percent nationwide. This segment's continued viability is due to five major factors — increasing consumer demand, low capital requirements, high capitalization rates, low operating costs, and development restrictions — that help self-storage returns remain competitive with other real estate investments.

Demand Feeds Growth Potential

Many self-storage operators speculate that only about one-third of the U.S. population has rented self-storage units. Over time, the number of users likely will increase as consumers not only discover self-storage but, more importantly, use it again and again. In fact, many seasoned storage facilities operators report that repeat customers constitute up to 50 percent of their business.

For instance, assuming the national population growth is 1.2 percent per year and the rate at which consumers discover and use self-storage is 2 percent, during the next decade about 20 percent of the population will learn to use self-storage. This translates into total demand growth of about 3.2 percent per year, or roughly 267 percent more than property types dependent on population growth alone (3.2 percent total growth in storage demand divided by 1.2 percent national population growth).

Self-storage's growth also receives a great boost from consumers moving up the earning curve. As potential customers earn more, their ability to afford the use of self-storage is enhanced. For example, as customers in their 20s move into higher income levels they simultaneously become more aware of the use and availability of self-storage. Thus, the ability of customers to earn more works synergistically with awareness to enhance self-storage demand.

Local markets also play an important role in enhancing self-storage demand. Economic generators such as major employers create new self-storage development opportunities by providing the underlying basis for economic expansion and the direction of growth corridors. Also, with the proliferation of major national self-storage companies' advertising, more consumers are becoming aware of self-storage's benefits and availability.

Another hard-to-quantify factor that affects growth demand is the fact that self-storage doesn't require people to make it profitable. Hotels, apartments, offices, and homes all require occupants, but self-storage thrives on peoples' accumulation of goods and their emotional attachment to them. Americans simply have more stuff and less home storage space than ever before. Also, boat and recreational vehicle storage facility demand is flourishing because many residential areas do not allow street or driveway parking of such vehicles.

Ever-increasing add-on sales further drive the industry's growth. For example, it is now common for self-storage facilities to offer space for large items such as boats and RVs as well as related services such as car washing, shipping, and selling packing supplies, which complement the business and increase profit margins.

The net result of these factors shows that self-storage demand is on the rise for the time being, which also is illustrated by rental rate growth during the last 25 years. Despite the industry adding approximately 30,000 facilities to the inventory, rents have continued to increase.

Few Capital Requirements

Unlike other real estate investments, self-storage capital demands are very small: a new broom every three months, according to one industry investor. Witticisms aside, a standard capital reserve in the industry is about 10 cents per square foot.

The following example demonstrates this comparison. An office building's tenant finish allowance ($25) and commission ($5) amortized over seven years is $4.66 psf per year at 10 percent interest, but the reality is that all of the costs are expended upfront and not amortized. The office rent is $24 psf with $8.50 psf in expenses less $4.66 of capital amortization for a net of $10.84 psf per year. In contrast, a self-storage property's rent is $12 psf with $3.50 psf in operating expenses (including reserves) for a net of $8.50 psf per year. The self-storage facility costs $40 psf to build, while the office property costs $100 psf to build. The uncertainty of the amount and timing of the office building's capital costs compounds the risk of the large capital requirements. In other words, the capital may not be available when needed, such as when a key tenant moves out.

Competitive Cap Rates

In a comparison of national cap rate averages for different, competing real estate property types, self-storage returns generally are higher than most other investments. For property types with competitive cap rates, self-storage's income stream generally is more stable. For example, an office or warehouse tenant moving out has a greater effect on the property's occupancy rate and income than a customer vacating a self-storage unit in a 500-unit facility. While the national statistics show self-storage cap rates in the mid-9 percent range, facilities in many areas are selling in the 10 percent to 10.5 percent range. (See Table 1.)

Table 1: National Capitalization Rate Comparison
First-quarter 2003
Property Cap rate

Suburban office

Strip centers 9.58%
Flex/R&D 9.55%
Self-storage 9.52%
CBD office 9.40%
Power centers 9.35%
Warehouses 8.84%
Regional malls 8.73%
Net leases 8.71%
Multifamily 8.14%
Source: Korpacz Real Estate Investor Survey

For leveraged self-storage investments, the difference in cash-on-cash returns is impressive. For example, compare a self-storage facility at a 10 percent cap rate to another real estate investment with the same net operating income at an 8.5 percent cap rate with leverage (mortgage at 75 percent loan-to-value, 6.5 percent interest, and 25-year amortization). The self-storage property's cash-on-cash return is 13.4 percent versus 7.4 percent for the other investment — a 77 percent return increase due to a 1.5 percent cap rate change. (See Table 2.)

Table 2: Office and Self-Storage Investment Comparison
Office Self-storage
Cap rate 8.5% 10%
Net-operating income $100,000 $100,000
Sales price $1,176,000 $1,000,000
Loan-to-value (75%) $882,000 $750,000
Equity $294,000 $250,000
Debt service $78,200 $66,500
Cash flow $21,800 $33,500
Return on investment 7.4% 13.4%

Low Operating Costs Self-storage operating costs usually have limited exposure to volatile energy and labor expenses, so risk is reduced and income consistency is improved. Also, while insurance premium increases have adversely affected other property types, such increases for self-storage have been relatively stable. Thus the selective advantage of self-storage over other real estate investments is the low break-even rate. Depending on the property's size and location, experiencing break-even rates in the 60 percent to 65 percent range is not uncommon.

Owning and developing self-storage is more attractive when the low break-even rate is coupled with current tax advantages and after-tax benefits. For example, more depreciation can be realized sooner rather than later by cost segregating the components of a self-storage development or purchase, thus yielding a time value of money benefit.

Entry Barriers Restrict Competition Obtaining zoning for self-storage is becoming more difficult in many communities because it is not a glamorous property type, and it contributes no sales tax and modest real estate tax revenues. These factors tend to restrict additional self-storage developments and increase existing facilities' cash returns as demand builds.

Another barrier to entry is the increasing price of land for competing sites. Thus, the combination of price and zoning allow current owners in a particular market to raise rents and maintain occupancy.

Low Glamour Equals High Returns One of the main reasons self-storage is such a stable real estate investment is both a blessing and a curse: the lack of glamour. It is a blessing because all of the return comes in the form of cash flow. The curse is evident when it's time to sell: Buyers are seldom so smitten with a self-storage facility that they fall in love with a project and forget the numbers. Most buyers already own a storage facility, know the market cap rates and the operating costs, and refuse to overpay. Thus, while owners can earn good returns, they aren't likely to sell a project in the current market on cap rates much different than when they bought the facility. As the market becomes better educated on self-storage, cap rates may decline somewhat and increase selling prices, but in the meantime owners should just enjoy the steady returns.

C. William Barnhill, CCIM, and Michael McCune

C. William Barnhill, CCIM, is president of Omega Properties in Mobile, Ala. Contact him at (251) 432-1287 or  Michael L. McCune is president of Denver-based Argus Self Storage Sales Network. Contact him at (303) 785-6087 or