The Great Battle

It is an age-old question among real estate investors: Where do I put my money? The self-storage industry has only recently been invited into this competition for comparison with stately shopping centers, glass and chrome office buildings, amenity-rich apartment complexes, not to mention grand hotels of the rich and famous. In the past, ours was just the lowly business of garish garage doors attached to tin buildings, catering to the guy with snow tires and a leaky boat to store.

However, over time, the demand for our product and the resultant cash flow has attracted lenders and investors. The self-storage industry even earned a special report in PriceWaterhouseCoopers Korpacz Real Estate Investor Survey in 2003.

Like any beauty contest, the great battle of real estate types has some subjective and quantitative measurements that help us make the choiceor at least understand the differences. But as we explore this comparison, I will attempt to leave out contrasts that are aesthetically or emotionally driven, because these characteristics are usually decided in the eye of the beholder rather than by some quantifiable measurement.

That being said, I acknowledge that there may be some significant emotional value attached to owning the grandest hotel in town that loses just a little money vs. the meager self-storage facility that makes money hand over fist. The following analysis will look at several aspects of the real estate investing decision to which we can apply objective standards in our evaluation.

We will review strip shopping centers, suburban office buildings, flex R&D projects, warehouse buildings and apartments.

Just a word of caution before we proceed: We are only considering relatively successful, well-conceived and well executed projects. General rules do not apply to sub-par projectsthats why they are often called workouts.

Investment Return

The Holy Grail of investments is their potential return. Sophisticated investors understand value is based not only on current cash flow of a property, but its future value when sold (residual value). Obviously, the returns in both categories must be measured against the actual investment made in the property.

The best measure of total returns is the overall capitalization rate (OCR) being applied to properties recently sold in the marketplace. This number reflects the total annual return expected by the buyer when purchasing a property. The OCR encompasses the expected current return and the residual. The numbers presented in the accompanying chart are from the first-quarter 2003 Korpacz Real Estate Investor Survey and represent national averages.

A higher OCR generally means a property type is perceived to be more risky, thus demanding higher returns in the marketplace. As we can see by the relative OCRs, self-storage has some very credible company in the real estate business. While apartments seem to be more attractive to buyers, their OCRs may be an aberration, mainly caused by the relative lack of sellers. OCRs have generally gone down over the last year, but the relativity appears to be similar, although there are no definitive reports.

The result of this comparison is most other property types dont materially yield more per dollar of investment than selfstorage. Thus, we will have to look at other characteristics to see which category leaps to the front of our battle!

Obviously, every return comes with a risk, and many experienced people in the market will tell you all the risk is discounted in the price. As you can see in the OCR for hotels, there appears to be some higher level of risk indicated. However, we will explore the generic risks (those that are not site-specific) and let you see how those of the self-storage industry stack up against other real estate and determine if they are indeed reflected in the price or cap rate.

Strip Shopping Centers

The local strip center was once considered the gold-standard investment, almost immune from risk. An anchor grocery tenant with a long-term lease, good credit, and the ability to draw clients to other tenants who paid good rents was a great investment. Then, along came the large discount markets and Wal-Mart Super Centers.

About 1,300 supermarkets closed in 2002. Wal-Mart is clearly becoming the largest grocer in America. A Wal-Mart Super Center in a neighborhood will cause a real problem for a nearby strip center, even if the anchor grocer survives. Traffic will go down, and the Wal-Mart outlet may have competitors for the stripcenter tenants, i.e., barbers, banks, optometrists and even McDonalds. If this mega-store phenomenon continues, some anchors may be in serious trouble; and the owner of a strip center with a closed anchor is in big trouble! That is risk spelled with a capital R.

Suburban Office

Though office-market occupancies across the country continue to deteriorate, there is still a demand for office buildings at nice cap rates. However, the real issue is that a typical multitenant office building has a very high turnover cost; commissions and tenant-finish costs often amortize out at $5 per foot per year. This means lots of continuing capital costs and low gross margins.

With jobs a problem and an overbuilt market, the overall national vacancy rates are peaking at 20 percentall this while rental rates have plunged. For example, rates in Denver have dropped from about $25 per square foot to $16 per square foot in roughly 18 months. When expenses are considered, that means net rents dropped almost 50 percent, plus occupancies dropped 20 percent. This isnt the first time this cycle has been seen in the office market during the last couple of decades.

Flex R&D

This real estate type has a history about as long as that of self-storage. An early success generated a lot of supply in the small-tech manufacturing and distribution business. As that market grew weaker, excess supply overcame much of it. The market has improved marginally because this space can compete with traditional office space at cost. However, the configuration lacks many of the amenities users seek. In some respects, this is a product type that is still looking for a defined market. Many leases are short (five years or less), rent concessions are high, and there is still a lot of product around.


As witnessed by the lower OCR, investors think warehouses are less risky businesses than most real estate types. While vacancies have increased, the industrial leased investments remain strong, with long leases and good-credit tenants.

The long-term risk is obsolescence, as warehouses have grown larger and higher, are of different dimensions, and have varying amenities in recent years. Warehouses are very similar to self-storage in that the demand is not directly related to people occupancy, but rather depends on storing stuff. There has been some concern that because of improved, just in time, computerized inventory controls, the need for warehousing might decline substantially.


The OCR on hotels indicates investors compensate for risk by demanding a higher return. This seems warranted, as 2002 recorded the lowest occupancy in over 30 years. The economic slowdown has caused businesses to reduce travel costs significantly. While much of these savings are related to the economic cycle, there is also a fundamental cost-cutting mentality in much of American business.

Combined with more travel hassle, the outlook is difficult for the industry. In addition, the net operating income of hotels is usually lower in relation to the total revenues, giving the properties a lower operating leverage. Allowances must be made for frequent replacement of furniture, fixtures and equipment, which can create quite large capital investments.


Apparently, investors believe the risks on apartments are manageable and the future bright, if they are willing to accept an OCR of 8.14. Although occupancies are down to low levels and many markets are overbuilt, there remains optimism that apartments will retain value. It is interesting to note low interest rates may have actually hurt the apartment business, as many renters have now become buyers of homes. The math, of course, works if the buyer needs an 8.14 percent return, and a renter can get a house for 5.5 percent plus a tax deduction.

Apartments also mature very fast, so there is a lot of obsolescence in older units that cannot now compete for the higher rental rates and occupancies. Large projects of recent vintage appear to compete for higher rents based on size, amenities and marketing efficiency. Additionally, apartments require large capital infusions to remain competitive (carpeting, paint, appliances, pools).


Self-storage is not a business without some consequential risks. However, there are many benefits when compared to other real estate types. The business is subject to economic cycles, albeit less than the general economy.

Self-storage has low continuing capital costs. In fact, most appraisers suggest the reserves are only about 25 percent of those required for office and apartments. I believe they are even less. Self-storage operating costs as a percent of revenue are quite modest when compared to hotels, apartments or office projects in general.

The demand for the product is not tied to a growth rate in population but rather to peoples growing wealth in material possessions. Additionally, there is strong evidence that many customers are still learning to use the product and the learning curve will continue to increase the total growth for some time. Rental rates have shown overall growth (even if modest) in recent years, despite a building boom in self-storage.

Zoning planners continue to look at self-storage as an unwanted but minimally necessary and somewhat limiting competitor. This is also related to the fact there may be no sales tax on self-storage to encourage their approval.

So where are all the risks? The major risk is, of course, overbuilding. While this is a universal risk in all types of real estate, there are some particular elements that make the situation more critical in self-storage:

The nominal dollars are not large, and lenders are less cautious, particularly if the borrower has a little experience and some net worth. Many lenders have little or no experience in self-storage, making their judgments questionable in any event.

  1. Many projects get built without valid feasibility studies that take a critical look at the underlying demand.
  2. There is a mistaken perception that experience is not very important in developing self-storage projects.
  3. New projects tend to be much larger than in the past.
  4. The industry statistics currently being used are the product of highly speculative surveys.

Will growth offset these overbuilding issues? Lets just see how significant a little overbuilding can be in a market. Well use a hypothetical market area by way of example. Lets say a market contains six self-storage properties, each with an average of 50,000 square feet and an occupancy rate of 88 percent. While total square footage is 300,000, total actual demand is only 264,000. Now lets say a new, 85,000-square-foot property enters the market. The actual demand of the market does not change, but now there are 385,000 square feet of storage. This means the average occupancy rate declines to 69 percent.

In this example, if the demand grew at 5 percent per year, it would take 5.5 years for the demand to return to the previous 88 percent occupancy. During this time, there would be considerable pressure on rental rates, particularly in the less-competitive facilities. If the demand were only growing at 3 percent, it would take 8.5 years to get back to the previous average occupancy.


Self-storage is a maturing real estate property type, and comparisons can be made with other properties. According to our little study, the returns for strip centers, suburban offices, flex R&D and selfstorage are about equal, indicating the investment community perceives the risks to be about the same as well. They seem to think apartments are a lot less risky, and warehouses somewhat less.

Although the relative risks are hard to quantify, the major risk in self-storage overbuildingis one over which the industry could take some modest control. Overbuilding can ultimately be moderated by having well-informed lenders, using and developing industrywide, reliable statistics, and requiring statistically relevant feasibility studies for new projects. To date, there has been little demonstrated resolve on the part of the industry to control this overbuilding, and all owners will suffer the consequences.

However, no one will really know what the risks are until the battle is over and we see the long-term results of our investments. Thus, as you review the risks outlined here, you will develop a notion of the relative risks and rewards and an opinion about them. The relationship between risk and reward in real estate investing is often one that is computed in the stomach rather than the brain! Good luck.

Michael L. McCune has been actively involved in commercial 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 nations 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; visit

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