The Math Behind the Self-Storage Makeover
|Copyright 2014 by Virgo Publishing.|
|By: Doug McCarron|
|Posted on: 07/02/2007|
Many consumers in recent years have tapped into their mortgage equity to go on home-makeover sprees. Drive through residential neighborhoods and, chances are, you’ll see trucks for remodelers, kitchen and bath firms, and construction companies dotting the streets. Homeowners make these renovations not only to enjoy their spacious new media rooms and gourmet kitchens, but to increase their home’s worth.
Shift now to a neighborhood you drive through every day: your self-storage site. If renovations can help a homeowner’s property value, can upgrades translate into similar benefits for a storage facility? The answer depends on whether you plan to keep your facility for the long term or have a short-term ownership horizon.
The construction market can certainly impact the decision of how long to hold onto a property. New self-storage developments are being built in the $60- to $90-per-square-foot range in some markets. Many of these facilities include upgrades such as individual door alarms, keypad entry, climate control, and upscale rental offices with conference rooms and Internet cafes for renters. Consumers look for these amenities when renting units. If high-end facilities are your competitors, you have to determine whether similar renovations to your facility will pay off through greater occupancy levels or higher rental rates.
Before you pull out the hammers and start ripping up your façade for a facility makeover, examine your local market to ascertain the number of newly constructed facilities and their rental premiums. Also consider your current occupancy level and your strategy for holding or selling the property. This analysis will help you determine if the capital investment in upgrades will truly pay off.
Renovating for the Long Term
If your investment strategy is to hold your property for the long term and competitors are achieving rental premiums for facility upgrades, then a makeover may be in store. Of course, your first concern will be expenses. Whether you want to repave your driveways, add new access gates, update your rental office, add individual door alarms or install new security monitors, you’ll need to gather cost estimates. If the costs are within your budget and the projected return on investment looks promising, consider proceeding.
A phased approach may be your best bet when making renovations. Not only will this strategy conserve cash flow, it will allow you to raise rents in stages.
For instance, let’s say that during Phase 1 of your makeover you update the security system with 12 new cameras and two flat-screen monitors in the office. After the installation, you raise rents by promoting the facility’s new security features. Then you move into Phase 2 by adding individual door alarms, thus warranting another increase. Phase 3 features new access gates, landscaping and keypad-entry systems. During Phase 4, you repave the driveways.
After each phase, your manager should send letters to renters promoting the upgrades and their corresponding benefits, and making a direct connection between these renovations and rent increases. Although tenants will have to pay higher rates, they will appreciate upgrades that create a more secure and pleasant storage experience. True, they’ll question why they have to pay more; but they’ll be able to visually connect the higher rent with a correlating increase in value. If some tenants terminate their leases because of rate hikes, you’ll be able to rent those vacant units at a higher price.
This phased strategy will help you recap some, if not all, of your remodeling expenses, improve your cash flow, and make your location more competitive for the long term. It will also prove to tenants that you are making tangible efforts to create a more positive rental experience.
Sprucing Up for the Short Term or Possible Sale
If your ownership horizon is short and you’re considering upgrades before you sell, put aside the hammer for a moment and pull out a calculator to analyze the numbers. A major misconception in the market is investors only purchase updated self-storage facilities. This is simply not true.
What investors are really looking for is upside potential. If your facility is currently hovering in the 65 percent to 75 percent economic occupancy range, a potential investor may conclude that property upgrades will stabilize the deal and pay you for that likelihood. Conversely, if you update the facility and it still hovers in the 65 percent range, potential investors may decide there’s something wrong with the market and will not apply an aggressive value to your property.
For example, let’s say an investor is comparing two facilities for separate acquisitions. Property A is an older facility that is 65 percent economically occupied, has an outdated office, cracked asphalt driveway, no security system, aging paint, and in clear need of a makeover. Property B is also an older facility with 65 percent economic occupancy, but $150,000 in renovations in the past year resulted in an updated office, new pavement, individual door alarms and a state-of-the-art security system. The properties collect the same rental rates per square foot and are in similar markets.
If both are listed for sale at $4 million, the one that will likely stand out for investors is Property A. Because this facility needs a makeover, a qualified real estate broker can present a case that if a new investor were to purchase and update it, he could stabilize the deal and create a significant return on his investment.
The reality is without making upgrades, you’ll get paid for most of the upside without taking the risk or expending the capital required for renovations. Most self-storage transactions are valued on a pro forma basis. In the pro forma, a broker will value your property on a five-year hold, adding a monthly 2 percent to 3 percent lease-up velocity and annual rental-rate increases of 3 percent to 5 percent, depending on the property and market. In turn, the investment community will pay you for the property’s potential.
An investor will not project an aggressive lease/rental-rate increase structure on a property he believes has no upside, which will have a tremendous effect on the final sales price of the updated facility. The tired facility will have a much more aggressive structure because there’s a stronger case for upside potential, thus supporting a higher sale price.
Doing the Makeover Math
Going back to our example, both properties still have 20 percent of economic occupancy upside left until stabilization (typically, stabilization is at 85 percent). The updated Property B will have a less aggressive monthly lease-up structure, perhaps 1 percent to 2 percent if occupancy stays constant in the six-month time period.
Since the deal is not going to be valued as aggressively, an investor may be willing to purchase the property for $3.4 million at a 7.5 percent initial cap rate and a net operating income (NOI) of $255,000. However, the buyer will not have to shell out $150,000 to update the property. The end result is a $3.4 million purchase price minus the $150,000 in improvements, which nets the seller $3.25 million.
The outdated Property A will be viewed more aggressively given its upside potential. An investor may apply a monthly lease-up velocity of 2 percent to 3.5 percent, as well as annual 3 percent to 5 percent rental-rate increases that will stabilize the deal faster and add more to the NOI. The investor will plug in the $150,000 capital cost for updating the facility and spread it across a five-year hold. In this case, let’s keep the dayone NOI constant at $255,000.
An investor would be willing to pay $3,642,857 at a 7 percent initial cap rate given the projected aggressive leaseup structure and annual rental-rate increases. This outdated property offers better upside potential and thus attracts a more aggressive purchase offer. The net amount achieved by the seller of Property A is $3,642,000, or $392,000 more than the owner of Property B, who upgraded his facility prior to the sale.
Further, Property A’s owner did not have to use cash for any improvements or deal with the hassles that come with any facility renovation, and he still put more money in his pocket at day’s end. A tired facility may look worn, but beauty is in the eye of the beholder. And for self-storage investors, beauty comes in the form of upside potential.
Before you update your property for a sale in the short term, analyze the numbers to determine if a makeover makes good economic sense. Have a self-storage broker complete a valuation analysis of the property’s current condition—most brokers will likely provide it at no cost.
If you’re looking to own and operate your facility for the long term, pursue the makeover to stay competitive. But if you’re considering a possible sale in the near term, it may be wiser to maintain your facility “as is” and achieve a more aggressive sales price in today’s marketplace.
Based in Los Angeles, Doug McCarron is a partner at Storage Investment Advisors (SIA), a self-storage investment real estate services firm whose main office is in Houston. He can be reached at 310.908.4728 or firstname.lastname@example.org. For more information, visit www.siallp.com.