posted Wed, Dec 02, 2015
For many years, self-storage was a called a recession-proof investment by owner/operators in the industry. This designation was based on anecdotal experience from those of us who had run multiple facilities in multiple markets for at least twenty years. It made a good story, but like most business stories, it glossed over many salient facts in order to tell a compelling, albeit misleading, tale.
The consistent growth and lack of failure in self-storage development was a function of historical circumstances that consistently benefited this asset class. This notion will be vehemently challenged by maverick developers and REIT executives who can tell you what they have uniquely executed to become over-achieving successes. Being in the right place at the the right time and not making a catastrophic error is a more accurate explanation. California and Texas were the birthplace of the business in the seventies, serving as a precursor and testing ground for the national growth of self-service storage facilities, and the industry emerged in the eighties across all U.S. markets. High interest rates at the end of the Carter-era put pressure on landowners to generate revenue from their holdings. The lingering recession impeded the opportunities for traditional real-estate plays like office and retail; without economic growth, new buildings were not needed. With interest rates at high double-digits, the proforma for a self-storage facility was not particularly promising, but they were more enticing than simply servicing the land loan out-of-pocket. At this time, prefabricated metal building companies had established a stable industry with consistent design, fabrication, delivery, and erection. Building departments gave minimal push-back to these packaged products, and few municipalities had yet established guidelines on the ascetic presentation of self-storage projects. Furthermore, retention/detention of surface water had not become a critical planning issue for most communities. Simply put: it was cheap and easy to build self-storage.
By the end of the eighties, self-storage operators were seeing solid returns on their ventures. Declining interest rates and looser lending practices promoted additional growth of the industry. The next big push occurred in tandem with the S&L crisis. Failed/failing institutions began off-loading REO at prices extremely favorable to developers. The land portion of a self-storage development deal cost only 10% of the budget as compared to the 25-30% that is typical today. Pricing got even better when the RTC took over hundreds of failed thrifts and began fire-sales on property. Self-storage developers in Texas and California maximized this opportunity. It is estimated that the national inventory of self-storage doubled between 1995-2006. In just over a decade, the amount of product increased by a factor of two. No other real estate class has experienced this type of growth, and self-storage developers took this as normal and continued to grow as fast as they could. This growth was further fueled by syndicators who saw an opportunity to take a highly visible, poorly understood asset to overly eager, uninformed investors. A broad range of debt products promoted the growth at a still faster rate. Only the stoppage of virtually all real-estate growth halted the expansion of the self-storage industry in 2008. And at that time, we found out that self-storage is not recession-proof.
Self-storage is recession-resilient. Occupancy and rates dropped by over 10% industry wide (Some sources reported this as low as 6% and some up to 15%). Smaller markets were hit harder. The nature of the asset is the source of its flexibility: self-storage facilities typically have a 50% annual churn rate. A good facility loses half of its customers every year. The larger than average move-out in 2009 certainly caused damage to the bottom line, but the decrease in occupancy and resultant discounting was an increase in a normal business process not the introduction of new problem. The industry also benefited from other consequences of the recession. Homeowners downsized and utilized self-storage. Businesses broke retail leases and moved inventory and fixtures into self-storage. Business expansion was non-committal and preferred month-to-month leasing in self-storage. By 2011, the industry had recovered from the setback and started a new development cycle.
Self-storage is an industry that is moving into adulthood. There are an estimated 45,000-50,000 self-storage facilities in the U.S. Only about 15% are controlled by institutional owners, and another 10% are owned by large, private companies. That leaves a huge portion of the asset class in the hands of very small operators. The institutional entities are highly concentrated in core MSA’s, and they continue to focus on expansion via acquisition rather than construction. This indicates a growth opportunity for developers able to identify and develop in-fill sites in major MSA’s. The REIT’s want to acquire because they can quantify growth and risk within their business model. They buy an existing facility in California at a sub-5% cap rate because their cost of funds is zero. They add 2% in expenses to cover their high administration fees, and they can continue to return a 3% dividend to their stockholders while their stock price increases 14% for the year. New development creates a revenue void during lease-up and introduces the uncertainty of lease-up projections. The large private companies have a different set of challenges. In particular, they are driven to grow because of their increased administrative expenses as they grow. They are disinclined to pass on marginal deals and they look for cash streams from non-core sources. For example, they handle a lot of third-party property management contracts. They deny that there is any possible conflict in interest, e.g., a poorly managed property has low revenue causing the owner to sell and the property management company informs another client (or themselves) of a good buying opportunity. The principals are also investors and they disavow in problem in cherry-picking the best deals. The next tier of operators is the large independent, running between 10 and 20 properties. The two biggest challenges to this group is raising equity when a good deal is found and keeping growth down so that a new level of administration is not required. The conflict of these two points is evident: your business can grow but growth creates a problem you have not handled before. Lastly, the single facility owners are preserving what they have; their business model is usually to do what they have always done and hope that nothing bad happens. There is rarely an exit strategy in place.
The interesting part about all the challenges described above is that none of them have anything to do with self-storage. They are business model issues, and there are many resources available for effective business management. We, self-storage operators, tend to come from small business models, and we tend to be better at running self-storage than building the business operations. It’s common to find a self-storage operator who has let their facilities slip while trying to figure out what they want their business to look like. The more effective route is to find outside assistance in reorganizing to accommodate for expansion.
The successful operator is the one who is still looking for the next good acquisition or development, one project at a time. Self-storage is fundamentally a 10 cap business. There are plenty of appropriate reasons for buying or building below that rate, but it needs to be justified for explicit reasons. The industry is at the furthest reach from this pricing, and there will be a correction, just a surely as the interest rates will go up. There are thousands of fundamentally unsound self-storage projects across the country, and many were on the verge of failure when financed at 6.5-7%. No action was taken by lenders on these non-performers, and refinancing at historically low rates bailed out these problem projects. Still, the problem of too-high first costs has not been resolved, merely delayed. When refinance occurs for these projects currently with a 85% LTV at 5.5%, they will have to add capital when the best financing option is 75% LTV at 6.75% with no interest only. When refinance coincides with historically average rates, these opportunities should abound. The two key areas for growth are infill development and opportunistic acquisition. The diligent, consistent, flexible self-storage operator will continue to find solid opportunities at all cycles of the economy.