Buy vs. Build
|Copyright 2014 by Virgo Publishing.|
|By: RK Kliebenstein|
|Posted on: 02/01/2005|
Many investors struggle with the decision to develop a self-storage property from scratch or acquire an existing site. Their answer is likely to be a matter of economics, but additional considerations should be included in the analysis.
This trite but true real estate notion of “location, location, location” could never be more important than in consideration of self-storage ownership. A mature firstgeneration store can easily compete with a state-of-the art property if its location is superior. Conversely, a poorly located store, such as one in an industrial park or at the end of a cul-de-sac, can be buried by a development project in a locale with higher traffic and better visibility. No sacrifice should be made when it comes to location quality.
Most investors would argue the choice to develop or acquire is driven by one of the purest of economic theories: risk vs. return. The following juxtaposition outlines the benefits and drawbacks involved in acquisition and development. A case could easily be built for either strategy.
Buy. There are few “deals” in the current market. In fact, it’s a seller’s market. Capitalization rates have never been lower (or prices higher), and thus returns for most projects are weak. Should a buyer elect to buy at a very low cap rate (7 percent?), all will be well—as long as cap rates remain low and continue to decrease. If cap rates rise, as some investors predict, buyers could face problems. The increase may outrun any gains in income from rental-rate increases.
Anticipated returns for an existing property may be down 10 percent to 12 percent cash-on-cash, and internal rates of return may be in single digits. It should be noted that the ability to leverage existing properties at a higher initial level than development sites affects this analysis.
Build. All-time highs in vacant-land costs coupled with unprecedented increases in raw materials and supplies have eroded developers’ yields. Despite this diminution in profits, the “pay day” in self-storage lies in new builds. The increase in value from vacant land to an operating business is substantial and almost always outperforms acquisition targets.
Pro forma returns for development projects (including the difference in leverage) are considerably higher than for acquisition. In fact, good development projects offer an infinite level of return at retirement if construction financing is in place, allowing the project to develop mature cash flows. Even with conservative pro forma incomes, most development projects will offer cash-on-cash returns in excess of 20 percent and internal rates of return at least in the mid-teens.
Buy. Typically, acquisition occurs after a project has reached stabilization. Given this assumption, the buy target has a “proven” market. Historically, unless there are extenuating circumstances, physical occupancies do not significantly erode over time. In fact, rental-rate growth provides for increased gross potential income and, ultimately, greater profit and value.
The lack of available properties means the location risk is typically fixed for buy targets. Since most markets do not offer a selection of acquisitions in various locations, “what you see is what you get” sites make this a static analysis. Great concern should be given to projects in sub par locations.
Product type, including amenities, may be fixed or limited by the physical attributes of the existing site. Demand for features that are not practical or possible at an existing property may put the site at risk. For example, if a facility cannot provide climate-controlled space, it may be unable to meet the needs of the market. A buyer should forecast the need for amenities that might increase costs, for example, the addition of individual door alarms.
Build. The inherent risk in development projects is the length of rent-up. The projected time to achieve stabilized occupancy is nothing more than a guess, hopefully an educated one. Pro forma lease-ups vary from market to market, depending on project size and type. They can range from 12 months, which is rare, to 48 months.
One of the beauties of the development opportunity is the ability to select the “right” site. While this is tempered by availability, if the risk is too great, the developer has the option of looking for an alternate location.
A “clean sheet of paper” in the development process allows new projects to meet current demand. It can also produce designs adaptable enough to meet future market needs and shifts at relatively low cost. Flexibility in the development plan may allow for the addition of amenities at less expense.
Deployment of Capital
Buy. Aside from risk adversity, the capital component is the largest advantage of existing projects. Typical leverage of up to 80 percent of the purchase price is available in acquisition financing. This lower capital requirement may allow the investor to spread risks over a wider variety of projects and locations. Sponsor quality and experience is not typically the driving influence for acquisition lending.
Build. One of the most significant barriers to entry in the development of self-storage projects is capital intensity. While every situation is unique, typical leverage requirements for a development project range from 65 percent of cost to 75 percent of appraised value at completion of construction. The level of leverage and comfort with the developer is typically dependent on the proven abilities and experience of the sponsors.
Buy. It is customary for acquisition loans to offer long-term, nonrecourse financing in which the strength of the property and proven cash flows are the primary strength of the loan. This may mean less stringent requirements on the borrower with regard to credit worthiness, financial strength and experience.
Build. While the value of a project must substantiate the lending decision, the primary criteria for construction lending are often based on the strength of the developer. This requires the sponsors to possess financial strength, development and/or construction expertise and experience, as well as a strong self-storage background. While not all-inclusive, this summary of salient differences in the buy vs. build decision can help. It is simply a matter of risk vs. reward.
RK Kliebenstein is the president and CEO of Coast-to-Coast Storage, a self-storage consultancy firm. From feasibility studies to financing, Mr. Kliebenstein has a wide range of experience and expertise in development and acquisitions. He can be reached at 877.622.5508, ext. 81.