AS WE ALL KNOW, EVERYTHING HAS IT'S CYCLE, and self-storage is no exception. The only surprise is the self-storage upswing has lasted so long. Many operators will say the cycle is not over yet, and we are happy to agree with them. Others, however, are beginning to feel the pinch from overbuilding in their trade areas.

In September, at the Inside Self-Storage Expo in Orlando, Fla., several speakers addressed the topic of overbuilding, including yours truly. Ray Wilson of Charles R. Wilson & Associates had some very interesting statistics in his presentation that indicate overbuilding may be occurring in some areas, and rents and occupancies are flat or down in many areas. The numbers show some of the declines could be--at least in part--due to increasing supply, i.e., overbuilding.

Additionally, the Los Angeles Times recently ran an article titled "Storage Niche Overpacked" (Sept. 21, 2002), which included charts indicating the number of total facilities, nationwide, has gone up 65 percent in the past 10 years. Another chart showed Public Storage's average occupancy dropped from 93.3 percent to 86.4 percent in the last two years. Let's explore some of the causes and ramifications of overbuilding.

Why Lemmings Race to the Sea (Overbuilding in a Nutshell)

The question is, what causes a market to become overbuilt? It is not much of a secret self-storage has become a recognized and respected real estate investment type. Some folks in the industry would like to take credit for promoting it, but the real fact is the product has been an incredibly successful and reliable investment. I suspect many owners have heard customers say something to the effect of "What a great business. How do I get into it?"

Combine the success of self-storage with the relative decline in the fortunes of other real estate and there is added pressure to build self-storage throughout the country. Office, retail and rental residential are all considered to be significantly overbuilt or about to be. One would expect prices of real estate would decline in this situation, but, in fact, in many cases, it has actually gone up relative to its income. Is this confusing? Yes, and that leads us to the next reason for all the interest in building self-storage.

Many of you may be unfortunately aware of the events in the stock market over the last 18 months. Because people and institutions have become more skeptical of relying on analysts' projections, there is suddenly a lot of money available for any kind of investment that produces regular cash returns. That has led to a rush to buy real estate, even in some of the lesser producing types. However, given the stellar performance of self-storage, it is in particular demand, especially by larger investors who have been traditionally involved in our industry--GE for example. When larger investors began to look at self-storage, they found the only way to enter the market on a relatively large scale was to develop for their own account or partner with an experienced self-storage operator.

Last, but not least, a result of overbuilding is cheap money. Interest rates are the lowest in 44 years. Not only does that make borrowing cheaper, it also makes the returns on deals much higher when leverage is employed. Developers are willing to assume more risk when the potential returns are high. For example, a deal that has a $100,000 net-operating income, a cap rate of 10 and leverage of 75 percent has a 10 percent cash-on-cash return with an interest rate of 9 percent; a cash-on-cash return of 14.7 percent with a 7 percent loan; and a whopping 27 percent return if you get a LIBOR-indexed, bonded loan at 4.5 percent. The magic of cheap (there is no other word for it) money on rates of return are so impressive it is no wonder so many new facilities are being built. Everyone knows the interest rates will change, so they are taking advantage of low rates while they can.

Why the Lemmings Drown (When Your Neighbor Overbuilds)

Assume for the moment we have a facility in the market area represented by the following chart. Each circle denotes a facility of 50,000 square feet (for a total of 350,000 feet in the market). Each facility is 88 percent leased, and everyone is reasonably fat and happy. A little math tells us the total demand for storage in the area is 308,000 square feet. A new developer comes to town, plops down a new, 70,000-square-foot facility with all the bells and whistles, and begins operations.

As a result, the world changes for everyone. The total demand now equals 73 percent of the built facilities. If you look only at the five facilities whose market areas are directly impacted by the new facility, the average occupancy drops to 69 percent (proportionately speaking). Now, if the new facility has a competitive edge in location or amenities, there can be a larger, disproportionate impact on the older facilities, especially if the new facility cuts rates.

Many new facilities with lower mortgage rates have a lower breakeven point and can afford to cut rates. While many owners don't believe cutting rates is "fair" competition, it happens all the time. Thus, overbuilding not only impacts occupancy, it may also have a negative effect on rental rates. If rates drop, say, 5 percent (it could be more) and demand drops 15 percent, think what happens to your cash flow after debt service.

How Not to Become a Lemming (Forewarned is Forearmed)

Here are a few thoughts:

1. Make sure city planners know the level of vacancy in your area so they can make intelligent decisions about new facilities. If you don't tell them, they won't know, and the new developer will control the information.

2. Ask the planners what projects are on the drawing board and which ones are likely to be completed.

3. Make sure your property is competitive--clean up, paint, advertise, market to local businesses and train your managers.

4. Be competitive in your rates. Don't accept vacancies.

5. Get competitive financing so you can compete and still make money.

6. If you are thinking about selling some time soon, sell when there is no competition on the horizon. Don't wait for a developer to steal your market and value.

Michael L. McCune has been actively involved in commerical real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real-estate consulting, brokerage and development company based in Denver. In January 1994, he created the Argus Self Storage Real Estate Network, now the nation's largest network of independent commercial real-estate brokers dedicated to the buying and selling of self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.