Sizing Up Self-Storage
New Trends Broaden the Appeal of This Popular Investment Property.
The self-storage property sector currently provides great opportunities for investors and developers across the nation. F.W. Dodge reports decreases in the number of self-storage property starts during the last five quarters, which bodes well for the supply/demand equilibrium. This indicates that developers and lenders are displaying the discipline required to maintain solid investment economics in this market.
While investment stability reigns, new trends in self-storage are cropping up in acquisitions, financing, and property development and management. A new set of buyers has emerged in the last few years, with access to institutional capital to expand their portfolios through acquisitions and development. In addition, while self-storage lenders aggressively are pursuing high-quality projects in major markets, they also have become increasingly sophisticated in their underwriting, aiding the whole industry by demanding the solid fundamentals necessary for success.
Local entrepreneurs continue to spearhead new self-storage development, with real estate investment trusts responsible for less than 10 percent of new development starts in 2000.
Total new starts in 2000 leveled off with approximately 15 million square feet compared with 22 million sf each in 1999 and 1998. Slightly more than 80 percent of new-start activity in 2000 began in the largest 65 metropolitan statistical areas and included nearly all of the new REIT development.
The spike in self-storage development during 1998 and 1999 held overall new development in line in 2000. Square foot occupancy for mature properties of the four REITs reporting in the first quarter of 2001 was 87.1 percent. This included more than 1,700 properties across an estimated 50 markets.
With self-storage occupancy up across many geographical markets, owners are enjoying strong cash flows, and sales activity has slowed in the past two years. But several REITs and large regional companies are looking to buy self-storage properties, particularly high-quality assets.
Although the largest segment of sellers continues to be local operators with one or two properties, merchant building has increased significantly, particularly in 1998 and 1999. Merchant building describes a short-term development strategy. Merchant builders are less yield conscious than long-term holders of self-storage properties. Instead, they seek to build, lease, and sell quickly, making their profit on the spread between development costs and stable capitalized value. Merchant builders currently are placing a large amount of new stabilized product on the market, some of which is prime for acquisition by cash flow investors.
The merchant-builder strategy includes locating and permitting land, building a new property, and selling it upon or just prior to stabilization. Stabilization is defined as 80 percent to 90 percent economic occupancy for 12 months. Economic occupancy is the amount of rent collected as a percentage of asking or gross rent; most developers refer to economic occupancy in their pro formas to determine yield.
Another emerging trend has been increased access to institutional capital by opportunistic buyers. In the last two years, several multiunit self-storage owners have structured equity deals with major institutions, including Goldman Sachs Whitehall Fund and Prudential Real Estate. With access to capital, these operators aggressively grew their portfolios through acquisition of existing properties.
“A number of joint ventures purchased or developed assets in the last few years with an exit strategy that proved unrealistic,” says Bruce Taub, senior vice president of acquisitions for Storage USA. “It remains to be seen, however, if these operators will exit with weak to zero returns, or whether they revise exit strategies to align with the expectations of today's buyers. Those investors interested in entering the self-storage market today should consider doing so with long-term, staggered exits unless market conditions are so compelling that they are literally forced to sell.”
Additional buyers include local investors, experienced self-storage operators, and REITs. Institutional buyers Storage USA and Shurgard, the second- and third-largest operators, have demonstrated access to external capital sources for acquisitions as well as development and continue to seek out opportunities. Storage USA has a $400 million joint venture with GE Capital, $240 million of which is allocated to acquisitions and the balance to development.
In addition to these traditional buyers, zoning-driven buyers have become more aggressive in the last few years. Zoning-driven buyers seek locations for other businesses, such as truck rental, and place more value on those businesses than the self-storage business. The largest of these includes U-Haul, which potentially can place more value on the truck rental business than traditional buyers, particularly in tight zoning markets.
Increasing Property Value
The self-storage business is highly fragmented and dominated by small operators, who may focus on maximizing physical occupancy rather than revenues and net income. Nearly all self-storage operating costs for facilities are fixed, so maximizing revenues while holding expenses in line creates profit and adds value.
In many markets, one or several properties may be 25 percent or more below market rents. Although lower rates may be justified due to location, access, or features relative to a competitor, these properties present favorable opportunities for buyers with strong management to boost value through rental increases.
In addition to raising rental rates, many property owners also offer auxiliary products and services to increase income. Renting trucks to customers and selling locks, boxes, and other packing supplies are the most common opportunities. Tenant insurance may be another profit center.
Some property owners negotiate ground leases with cellular tower developers and billboard companies, which add revenue with little or no cost.
With new, more-sophisticated buyers broadening the acquisitions market, operators considering selling must meet tighter standards. For example, today's buyers factor into their offers such items as deferred maintenance and environmental issues that are known but remain unsolved. Owners who delay maintenance such as roof replacement, major pavement repair, and painting can lower a property's value.
Additional items that negatively affect property value include lockouts, which do not allow prepayment of loans, and prepayment penalties on debt. Current owners preparing to refinance or new buyers seeking acquisition financing should attempt to minimize these items in the short-term. Even though the loans are assumable, given the disparity in costs of funds between certain sellers and buyers, lockouts and prepayment penalties will impact a property's value negatively.
Pricing has remained stable in the last few years, with capitalization rates on high-quality properties ranging between 9 percent and 11 percent on trailing 12-month net income. Trailing net income is net income (revenues less expenses) collected over previous months.
However, buyers do underwrite properties differently, and their analyses may apply cap rates to different sets of numbers. For example, some buyers will cap trailing six months, some a projected six months, and some a projected 12 months or more.
The cap rate also will depend on the particular property's location, features, and overall potential. For example, properties with upside in rental rates and occupancy may be underwritten on a projected 12 months, while a mature property with limited upside potential in the short-term may be underwritten on previous numbers. Properties with more upside also may command a slightly lower cap rate.
In addition, buyers must assess properly the risk associated with buying on pro forma as opposed to historical numbers. Also, pro forma numbers may be misleading if new competition is poised to enter the market. A new competitor will add supply to the market and likely cause occupancies to drop slightly. New competition also will make it difficult for rental rate increases until the new supply is absorbed.
In today's market, there is strong demand from lenders to place funds with quality assets. Facilities with great visibility, easy access, and generally moderate competition are more likely to be funded than those facilities with less-desirable characteristics.
Pricing is similar to other types of commercial real estate. For acquiring a stabilized income-producing property, buyers can expect 70 percent to 80 percent loan-to-value ratios, 1.15 to 1.25 debt-service-coverage ratios, and fixed rates based on reasonable spreads, such as 150 or more basis points over prime lending rate, LIBOR, or Treasuries, depending on the type of loan and the lending organization. Some pricing determinants include whether the loan is permanent, short-term (three to five years), or long-term (seven to 10 years). Prepayment penalties, lockouts, and the type of recourse will impact overall pricing. Amortization periods typically are 25 years.
Construction financing also is available to creditworthy borrowers or borrowers with strong guaranties. Construction lenders underwrite on loan to cost rather than loan to value to protect their downside. Builders can expect loan-to-cost ratios of 50 percent to 75 percent and spreads slightly higher than those found with nonrecourse financing.
Most loans are interest only for the first two years, which enables the property to be built and stabilized. The loans then convert to permanent status for an additional two years or longer.
Many large regional banks are lending on self-storage properties, as are several mortgage brokers that specialize in self-storage financing. Local banks also may be a funding source if the buyer has a relationship with that institution and the situation is right. Also, experienced buyers or developers that are packaging a sizable number of properties may be able to obtain more-favorable rates.
Overcoming Development Bias
In markets with relatively high barriers to entry such as the limited land for expansion in the Northeast, developing new projects continues to be a challenge. “In the last decade, approximately 200 million sf of new self-storage projects have been built,” says Rich Stern, senior vice president of development for Storage USA. “These new properties represent a substantial improvement over previous generations, yet many communities continue to view self-storage as a necessary evil for their residents or as the lowest rung of retail.”
Because other types of retail establishments collect substantially more sales tax revenue, self-storage is less attractive financially for communities. Many communities visualize self-storage as rows and rows of garage doors facing the road. They also expect crime to increase with a new property. These false perceptions make it challenging for developers to educate the public sector on the business from the get-go.
Developers in these markets often encounter both difficult zoning officials and building inspectors. “After educating the zoning board on the benefits of a new facility and making concessions like significant landscaping, the building inspectors often place self-storage in the retail bracket,” Stern says. “This bracket imposes unrealistic safety and parking codes that make projects uneconomic.” The net result is an increase from previous years in the amount of time and cost per square foot required to develop new properties in these areas.
The ideal size of a new property depends on a number of variables including the existing market supply, the available land, zoning restrictions, and the specific economics of each deal. The economics tend to work best for projects that can justify an office and a manager's quarters, greater than 50,000 leasable sf.
Developers can expect construction costs (excluding land) of approximately $30 psf for single-story properties to more than $45 psf for multistory properties. Prices will vary slightly depending on the building material and features. For example, the above costs are for block construction with a metal roof. Using all metal for the building material could lower the costs approximately $2 psf.
Site Selection Specifics
Many of the demographic and location parameters for successful self-storage projects are similar to retail requirements. Thus, self-storage developers increasingly find themselves competing against grocery/drugstore-anchored shopping centers for good sites.
Primary self-storage trade areas tend to be about three to five miles for non-central business district properties, so high population and business densities are important elements in site selection. CBD properties have even smaller trade areas, depending on the level of competition and market dynamics. In very dense areas, the primary trade area can be measured in blocks or walking time instead of miles.
The average self-storage customer base is composed of 30 percent commercial and 70 percent residential customers. The commercial segment includes nearly all businesses that need additional space for equipment, files, and other items, since renting self-storage space is less expensive than leasing traditional office or warehouse space.
Residential customers between homes usually have shorter average lengths of stay than commercial customers but make up approximately 50 percent of the residential customer base. In addition, 30 percent of the average property's customer base live in apartments, and 13 percent live in townhouses or condominiums. Therefore, the presence of dense multifamily development will improve the chances for success of a new project.
Nearly 30 percent of all customers choose a property from driving by it, so locations with traffic counts greater than 20,000 a day are ideal.
Competitive facilities with physical occupancy greater than 95 percent indicate strong demand for self-storage in a trade area. Demand for self-storage is very difficult to measure, but evaluating competitor occupancy and rental rates is the most-prudent method for assessing the current local supply and demand economics.
New Property Features
Once the exception, security features such as individual door alarms, a manager's residence, and video cameras have become standard on most new self-storage properties.
Climate-controlled space also is more common and can lead to a competitive advantage. Customers that intend to store items for long periods of time, especially business customers, prefer a climate-controlled environment. For example, pharmaceutical representatives who store sample drugs are required to keep those samples in a climate-controlled environment.
Most new projects contain about 25 percent to 35 percent climate-controlled space. In some markets, developers are building 100 percent climate-controlled facilities.
Other new self-storage development trends include multistory complexes and conversions of older buildings. Increased land costs have forced developers to build up, particularly in urban markets where land tracks of four or more acres necessary for single-story developments are nonexistent. In some cases, a multistory project can be built on as little as 1.5 acres.
Conversions of older buildings in urban locations into self-storage facilities also sidestep the lack of available land. The resurgence of many downtown areas provides ample opportunities for developers to rehab warehouses into self-storage. Other types of conversion opportunities include vacant big-box retailers, portions of neighborhood shopping centers, abandoned lumberyards, empty car dealerships, and closed movie theaters.