Capital flowed freely into the self-storage sector during 2005. While operating performance continues to support the record-breaking prices being paid for storage properties, investors are beginning to question the premium over replacement costs. Theres concern that pricing is ahead of the underlying fundamentals. Capitalization rates, which have declined to record lows, appear to have reached a plateau as investors realize the magnitude by which net income must increase to achieve their anticipated yield.

There are three issues critical to investors as they plan for 2006. First, they need to understand what drives demand and that demand changes as markets develop. They also need to recognize how location and quality affect a facilitys ability to sustain income over the long term. Finally, they must realize that taxing authorities nationwide are focused on self-storage, and the property-tax increase triggered by an acquisition will have a devastating impact on actual yield. Looking forward, the availability of investment opportunities seems to take precedence over concerns regarding storage demand.

Two-Tier Market

A two-tier investment structure is emerging from what has been a very cloudy and imperfect market. One level consists of the large private, public and institutional investors. The other is comprised of small investors, tax-deferred investors and individuals of high net worth. Both tiers have had access to low-cost capital.

The public and institutional investors are buying class-A facilities in major competitive markets. The small, private investors have been aggressive in their acquisitions too; but theyre mostly buying lower-quality facilities in secondary markets, which have fewer barriers to entry.

Investment Classes

Class-A facilities are well-located in markets where rent levels are above average for the region. In these areas, land prices and property values are high, and new development typically requires a lengthy entitlement process, which creates formative barriers to entry. These facilities trade in a cap-rate range of 6.5 percent to 7.5 percent. A premium of 50 to 100 basis points for portfolios is expected to continue, as there are fewer on the market.

Class-B facilities are usually in secondary markets, where there are fewer barriers to entry and more available sites at reasonable prices. They have been trading at cap rates between 7.5 percent and 9 percent.

Class-C facilities fall further down the scale in terms of quality and location. They typically trade at cap rates of more than 9 percent.

Cap Rates

The good news for sellers is cap rates are at their lowest levels in history. The bad news is they will probably start edging upward. Any further decline is unlikely considering a slowing of the overall economy, an expectation that interest rates will continue to increase, and the fact that most markets are becoming intensely developed.

There are three issues impacting cap rates. First, the lack of uniform asset classification has resulted in some facilities being improperly valued/priced and financed. Second, cap rates need to reflect possible increases in real estate taxes triggered by the sale. The investor who assumes a significant increase in taxes is justified in purchasing at a low cap rate. Ignoring the possibility of an increase, however, could prevent him from achieving his desired yield. Finally, the investment motivation driving the market is changing. Tax-deferred buyers (1031 Exchange) appear to be diminishing, and the aggressive acquisition mode adopted by the REITs also seems to be subsiding.

The competitive bidding for facilities should settle as investors become more concerned about premiums. Its becoming more difficult for them to achieve their desired yield without an enormous increase in cash flow, which isnt likely. Most investors interviewed for this article anticipate making numerous acquisitions in 2006; but the majority said they will not be as aggressive on pricing. Only in instances when they view a facility as strategic to their operations will they make hard-hitting offers.

Self-Storage Performance Index

The Self-Storage Performance Index (SSPI) allows operators and participants in the capital markets to track industry trends. It measures the health of the U.S. market by examining changes in key operating statisticsi.e., rental rates, occupancy, concessions and expensesfrom facilities in the top 50 metropolitan statistical areas. Specifically, it uses the asking rental rate on a 100-square-foot, climate-controlled unit as the benchmark for industry revenue. Data is gathered from sources public (SEC filings of self-storage REITS) and private (surveyed and contributed).

Lets take a look at statistics for the third quarter of 2005:

Consumer as well as investor interest in self-storage remains strong. While pricing is above replacement costs in several markets, operating performance continues to improve. The only major threat appears in markets where development is occurring despite a lack of demand and financial feasibility. The increased cost of capital will result in moderate increases in cap rates and contribute to a more conservative view of feasibility on the development side. As a result, yields will continue to pick up.

Note: The Self Storage Performance Index and other products referenced herein are copyrighted or trademarks of Self-Storage Date Services Inc. and are reprinted with the companys consent.

Charles Ray Wilson is the founder of Charles R. Wilson & Associates Inc., a full-service appraisal firm, and Self Storage Data Services Inc., a manager and publisher of economic and operating statistics relating to the self-storage industry. For more information, visit www.crwilson.com or www.ssdata.net.