The Real-Estate Market at the End of the Millennium

Where are we and where are we going?

By Michael L. McCune

The last fewyears have been very good for the owners of self-storage facilities. Clearly, the marketfor the ultimate product has been strong and growing. Nationally, the economy has beencreating actual, after-inflation growth in disposable income for the first time in manyyears. In general, interest rates have been low and have continued to fall. Best of all,there has been an abundance of lenders willing to finance and refinance self-storagefacilities. In addition to all this good fortune, the market for other types of realestate has roared back to health in the last three to four years. This increasedenthusiasm for all kinds of real estate has given many investors the confidence to investin more novel types of real estate such as self-storage. This happy event coincided withthe rise of the self-storage REIT, and has created significant demand and upward pressureon prices over the last couple of years. It appears that the years from 1996 to 1998 werespent "lining up the dominos" and made a great market for sellers ofself-storage properties. The phrase "It doesn't get any better than this"certainly applies to our most recent history.

As we start a new year and finish the current millennium, now would be a good time totake a break from reveling in our good fortune and take a hard look at where we are at thebeginning of 1999. Wanting to be as accurate and unbiased as possible, I have asked a fewindustry gurus to give me a hand in this examination. While I have solicited their viewsand quoted them liberally, they are responsible only for their own thoughts and notnecessarily those of the other experts or my observations and musings. To better organizethis exploration, I have attempted to break the analysis into some meaningful categories.

Cap Rates

First let me refresh your understanding of capitalization rates. Cap rates are simply ashorthand method of valuing real estate, including self-storage. This is really a measureof the return that investors are willing to accept in owning the property and the qualityof the project. Value (i.e., selling price) is simply the Net Operating Income (NOI)divided by the cap rate. For example, if the NOI is $1,000,000 and the cap rate is 0.11,the value of the property is $9,090,909. Likewise, if the cap rate were .095, the valuewould be $10,526,315. The cap rate is an easy way to relate value to the NOI and is thesingle most important variable in establishing value of self-storage facilities.

In other real-estate markets, cap rates have been quite volatile. For example, caprates for office projects of similar quality have varied over the last few years from .12to .08, and in some cases declined to .07. Hotels have varied from .13 to .08.Self-storage cap rates, for high-quality properties, have not shown the degree ofvolatility as in other types of real estate. With only small variances from the average.10 plus or minus, they have been relatively consistent over the last few years. When theREITs were very active in the high-quality market (1996 to early 1998), cap rates for thevery best properties were competing for what might have been somewhat less than theadjusted average. For the most part, though, cap rates for self-storage haven't changed agreat deal, even when cap rates for other real-estate types have changed by as much as 40percent or more. Ray Wilson, of Charles R. Wilson & Associates, an appraiser thatspecializes in self-storage, keeps very close tabs on actual cap rates and has found theaverage cap rate is close to .10, with a very narrow range of variance. And remember thata cap rate is also influenced by the quality of the project, so not all projects will getthe same cap rate.

What conclusions can we draw from these differences in cap rates between real-estatetypes? First, it gives us an indication that cap rates may remain more stable inself-storage than other types of real estate, even in less friendly markets. Also, I thinkit means that we have a very narrow and well-defined group of buyers that all think alikein terms of the returns they must receive. We will take a closer look at who the buyersreally are later, but first let us think about what the effect of newly constructedfacilities will have on the market.

New Facilities

With the real-estate market so strong in almost all parts of the country, it is nosurprise that there are many projects that have been built, are under construction orseriously being planned. Clearly, the increase in new projects means existing facilitieswill have to share the market with these new and aggressive competitors. This will have anaffect on both rents and occupancies if the demand for space doesn't keep up with the newdevelopment. Although banks have been more restrictive in their underwriting standardsthan they were in the 1980s, funds have been generally available for new projects.

It is almost impossible to get good estimates of the total area being added to theinventory of space, but we know that there is significant growth in many markets,especially in the metropolitan areas of the South and the West. The best indicators ofwhat impact the new facilities will have on the market is to look at the trend of rentalrates and occupancies. The latest national survey revealed an increase in vacancies and amodest decrease in rental rates. This would indicate that the new facilities are beginningto have an impact on the market in general. Since the economy has remained strong anddemand for the product has not declined, these changes in rates and occupancies cangenerally be attributed to increases in supply and competition.

What's in the future? We know that there are many more projects in the"pipeline" and that if the economy takes a spill, demand will be affected. Thecombination of a slowdown in demand for space and the completion of more new projectscould have a material impact on existing projects. The impact could be even more dramaticin localized areas where several new projects are being built and will compete foroccupancy primarily by reducing price. Being alert to planned projects in your area is thebest defense against nasty surprises in your market. Several of our brokers report that insome areas, as much as a 50 percent increase in space in a five-mile radius of someprojects is likely over a relatively near-term horizon. This magnitude of overbuildingwould certainly have dramatic negative implications for the projects involved. In theaverage project, a decline in rents of 5 percent and a decline in occupancy of 5 percentwould likely reduce the value of a project by about 15 percent. Therefore, overbuilding isprobably the single largest impact on future value of a self-storage project.

Financing

In the last five years we have seen many new lenders get into the self-storage market.Interest rates have fallen to the lowest levels in decades and the spreads (the amountadded to the Treasury Bond rates to determine the loan rate) have seen a decline from 400basis points (100 BP= 1 percent) to 150 BP at the lows. Everything seemed to be going welluntil October 1998, when we learned that even the self-storage industry could be affectedby the problems in Asia. Suddenly and without warning, with interest rates stilldeclining, spreads increased dramatically, causing some lenders to break commitments onloans and others to dramatically raise the quoted rates on loans not yet committed.Literally, within a week, many brand-name, Wall-Street brokers had essentiallydisappeared.

According to Neal Gussis of First Security Commercial Mortgage and Eric Snyder ofFinova Realty Capital, the market has begun to recover, but the direction of spreadsremains an open issue. Loan underwriting standards remain high with lenders having lessflexibility to take a deal that is not "standard." Both spokesmen said that newminimum rates have been established that will disregard the Treasury relationship if itdoes not result in high-enough rates. This means that even if Treasury rates go lower andspreads decline, the loan rates will not go back to the absolute rates seen earlier thisyear.

Several of Argus' brokers report that some banks--though not all--have tightened theirrequirements for self-storage construction loans and, in some cases, have even gotten outof the self-storage business entirely. This situation has a positive aspect in that it mayreduce the number of new projects that are built. However, there are also some negativesfor the owner that wants or needs to sell to a bank-financed buyer. It is clear that itwill be more difficult to obtain loans for prospective buyers even if rates stay down andspreads continue to narrow.

I asked both finance experts to give us their best thoughts on the direction ofinterest rates. Each thought that in the near term the rates would not likely rise much oreven fall a little, but added that spreads may continue to be volatile for some time tocome. Both Snyder and Gussis remain concerned that some international financial crisiscould again change the entire financing landscape overnight. Each also cautioned thatthere is still concern in the commercial-backed mortgage security market that investorshave a preference for Treasury notes making it more difficult to provide funding for theself-storage industry. In summary, the good news is that there is well-priced financingavailable for purchasers, but there is also substantially more uncertainty in thefinancial markets and more rigidity in the underwriting process, which will make sellingsomewhat more difficult than in 1998.

Where are the buyers?

This question really has two parts. The first part relates to what happened to theREITs and the "wannabe" REITs. Over the last couple of years, many owners becamequite sanguine that they could always call a couple of REITs and get a bidding war goingfor their property if they wanted to sell. The truth of the matter was that this was neverreally true. Even when the REITs were very active prospectors for new projects, they weregenerally very careful, analytical buyers and only bought from the upper levels of qualityprojects. The rumors of excessively low cap rates paid by the REITs were as much afunction of the various definitions of NOI, more than it was genuinely low cap rates.Also, many of the REITs had begun to shift their strategies to building new projectsrather than buying existing properties, because they felt that returns justified the risk.

When the stock market took its tumble, the REIT stock prices were down significantly,impairing and interrupting their access to capital. As I write this, the stock market hassmartly recovered most of its losses, but many REITs are still selling at significantdiscounts to the highs of the year. One REIT was even acquired by another, as it wascheaper to buy properties that way than to buy them on the open market. The REITs willcontinue to remain a major buyer of properties in the future, but they will be even moreselective and sensitive to value. If there is some major revaluation in the stock market,the REITs buying will certainly be further restrained. The REIT demand for facilities willbe concentrated in the high-growth metropolitan areas where they can achieve managementefficiency and will generally be for the best self-storage properties.

The balance and majority of buyers will come from sources that have been traditional inthe self-storage industry: other self-storage owners. While there has been much made ofthe industry's new visibility and acceptance by investors of other types of real estate,the fact remains that current self-storage owners buy the vast majority of all projectsthat are sold. Although there has surely been some new interest and acceptance ofself-storage on the part of institutional investors, that demand has largely been metthrough investing in the shares of REITs. Large institutions simply are not geared tomaking the relatively small transactions that are necessary in buying individualself-storage facilities. Brokers across the country see very little evidence that thereare many new buyers in the self-storage market for individual properties. They see a lotof "Looky Lous," but rarely do they turn into credible prospects or buyers. Afew current owners have forged deals with large investors--such as pension fundadvisors--to provide capital to purchase properties, but make no mistake, they areexperienced self-storage owners. As I mentioned earlier, this has tended to make the caprates less volatile because most owner-purchasers have a similar perception of the riskand returns involved in self-storage. In the future, as in the past, the majority ofserious buyers will likely be sophisticated and experienced in self-storage operations andvaluations because they are current owners. As financing regulations become morerestrictive, it will be the experienced builder/buyer who gets the job done. Inexperiencedbuyers will have a more difficult time acquiring sites.

Summary

One word seems to define the future market: uncertainty. There are some negatives, tobe sure, on the horizon, including such things as financing availability, economicslowdowns or recession and the investment direction of the REITs. However, there are alsomany positives that remain in the market: the consistency of cap rates, the demand ofcurrent owners for additional facilities and restrictions on financing that may preventfurther overbuilding. The consensus of Argus brokers is that the most likely scenario isthat the first part of 1999 will remain a seller's market, but with more difficulttransactions. As to the later part of the year and into the new millennium, the marketwill by then have determined its direction and we will have a clearer view of the future.But the odds seem to be against continuing to duplicate this almost magical set ofcircumstances that have driven the market over the last couple of years.

Michael L. McCune is president of Denver-based Argus Self-Storage Sales Network.For more information, call (303) 299-8820 or visit the company's Website at www.selfstorage.com.