Mirror, Mirror on the Wall

What is the fairest real estate investment of them all?

By Michael L. McCune

This article represents the inauguration of a new series of monthlyarticles for Inside Self-Storage dedicated to the real estate market. In thefuture, this column will offer a dialogue with industry experts on the state ofthe self-storage and real estate markets. Twice each year, our experts willfocus on each of five regions and national trends. However, we thought we wouldkick off the roundup with an article on why self-storage is such a great realestate investment. This article previously appeared, in part, in the MarketMonitor newsletter. I think you will find it interesting as well as encouraging.Next month we will look at the Northeast and poll our experts on what is goingon with real estate in that region.

Theself-storage industry has grown up over the last quarter century. In the not toodistant past, everyone in the real estate business thought those little"tin" buildings just couldn't be worth much--and they certainlyweren't very pretty. The institutional-type investors much preferred to run theboss out to a new luxury hotel or mega-mall and say, "Look at what we justbought!" As they were getting they're picture taken with the trophyproject, they thought about how great the picture would look in the annualreport. Meanwhile, the lowly self-storage developer was sitting at his kitchentable with pencil and calculator in hand saying something like, "Gee, thesenumbers sure look good." Slowly but surely, some of the real estate gurusbegan to catch on--after they stored some of their junk at a self-storagefacility, did a quick calculation of the rent per square foot and estimated thecosts.

During our rather brief history in the self-storage business, perceptionshave changed somewhat, but not dramatically. The facilities look better, but noone calls even the best self-storage facility a "trophy." Wall Streetendorsed some self-storage REITs, but now seems to have moderated its appetite.There was even a brief time recently when the folks east of the Hudson thoughtself-storage should be included in portfolios of real estate loans, but thatconcept, too, has now faded to near extinction.

A Hidden Beauty Is Found

Despite mainstream real estate investors continuing to yawn about theself-storage business, I thought we might explore the reasons they overlook thebest of all real estate investments. Having kicked around the real estatebusiness for the last 30 years--and having worked with just about every type ofproperty: office, hotel, industrial and retail--I am prepared to make anargument that self-storage may well be the best type of investment you can makein the real estate world. It is the "Snow White" of real estate--areal hidden beauty.

This is not to say all self-storage is better than all other real estate;but, on average, the income-producing characteristics of well- conceivedself-storage are better than those of other types of real estate. I must warnyou, however, my "mirror on the wall" only reflects certainattributes, such as product-demand growth, cash flow, return on equity,break-even risk, additional capital costs and other mundane numbers. If you'dlike the mirror to reflect more subjective criteria--such as annual-reportpicture value or suitability of a property as a location for your daughter'scoming-out party--my mirror probably will not suit you. So for the balance ofthis article, I am going to make several arguments about the relative merits ofself-storage investments compared to other types of real estate. Let's see howthis reflection compares and see if we think, like the Prince, we have indeedfound Snow White.

It Is a Growth Industry

One significant factor makes self-storage a better bet in the long run than alot of other real estate types: Its market is growing faster than thepopulation. First, only about one-third of Americans have ever usedself-storage. Second, after a period of time--say five years--many self-storagefacilities report most of their business--say 80 percent--is from repeatcustomers. If you look at what these statements mean, it is clear customers arenot only discovering self-storage but, more important, they are learning to useit repeatedly. The point is, the growth of self-storage is not limited to thepopulation growth in a market. It gets a great boost from "moving up thelearning curve" of the consumer.

Icing on the Cake?

There is one other factor that probably impacts growth demand but is harderto quantify, and that is the fact self-storage doesn't require a"body" to make it useful (although there may be one occasionally).Hotels, apartments, offices and homes all require human beings or they are notvery useful or profitable. Self-storage, on the other hand, thrives on ourfast-growing accumulation of stuff and our emotional attachment to it.

To get a perspective on the potential for self-storage in our society, justthink of all the things you are saving for your children vs. what your parentssaved for you. This is to say nothing of your own "toys" you can'tbear to part with but need a resting place. The net result is the demand forself- storage is growing very rapidly and in excess of the rate of populationgrowth--at least for the time being. We also know that fast growth in demandcovers a lot of sins in real estate, but it also enhances our ability to earngreater returns on our self-storage investments than other types of real estate.

If you want more proof of these arguments, think about what has happened toself-storage rents over the past 25 years. Despite the fact the industry builtapproximately 30,000 facilities in that general time frame, rents have continuedto go up, proving the total demand has exceeded the supply and the populationgrowth. Of course, you might say rents have gone up for all real estate types,and that is generally true; but when you think of the relative absorption ofsupply in such a short time, the story is truly remarkable.

Cash Flow

I am now going to explain five reasons the cash flow on self-storage ishigher--and probably more secure--than on other kinds of real estate. Thistranslates to higher returns on your investment, less risk and possibly higherprices. All of my arguments are based on the assumption a facility iswell-maintained, in a good location and in a rational market (i.e., one that isnot overbuilt). Remember: Even though we believe self-storage is the best realestate investment, this doesn't mean it will bail out "dumb deals."

Zoning. We all know that securing zoning for self-storage isbecoming more difficult in almost every community. It is not that self-storageis a bad civic citizen (actually, it's among the best); but it is not glamorous,there are no sales taxes and the real estate taxes are usually modest. Whatplanning commission in its right mind would ever approve a project that had noglamour and didn't produce a lot of taxes? This, of course, tends to restrictadditional development and increase cash returns of existing facilities asdemand builds. If you have a good facility, it is increasingly likely the localzoning board will not jump through hoops to help developers build potentialcompetition.

Cap rates. In Chart 1 (compliments of Ray Wilson of Charles RayWilson & Associates), you'll see some national averages of cap rates oncompeting real estate types. A cap rate is really the annual return you canexpect on your investment (i.e., a 9 cap rate equals a 9 percent return, etc.).As the chart shows, the returns on self-storage are generally higher than mostother real estate types. At first glance this looks like only a "sowhat" difference, but closer examination shows self-storage will yield 10percent to 20 percent more in annual cash for the same dollar of purchase price.

If you leverage your self-storage investment (i.e., get a mortgage), thedifference in cash-on-cash returns becomes truly impressive. For example,compare a self-storage facility at a 10 cap rate and another real estateinvestment with the same net operating income at an 8.5 cap rate. Thecash-on-cash return on the self-storage is 13.4 percent vs. 7.4 percent on theother investment (see Chart 2).

Capital risks. Often times, investors for other types of real estateoverlook the requirement (and risk) for additional capital. Hotels always neednew furnishing and redecorating; office buildings require massive amounts oftenant finish and commissions; apartments need everything and often. (If youwould like some detailed comparisons, drop me an e-mail and I will send you somestartling numbers on this capital demand.) However, as one industry wag puts it,self-storage has its own capital requirements to handle--a new broom about everythree months! While this comment is somewhat facetious, the capital demands of aself-storage facility are very small, not only in relative terms to other realestate, but also in absolute terms.

Operating costs. Once again, self- storage appears to have anadvantage because the operating costs for self-storage usually have only a smallexposure to volatile energy costs and labor. Many other real estate types haveas much as 70 percent of their operating costs consumed by energy and labor.Because of the lack of exposure to dramatic changes in these key expensecomponents, the risk for self- storage is reduced and the consistency of incomeis improved.

However, what is a blessing for self- storage is also, in some ways, a curse.The reason, of course, is the lack of glamour or, as one of my friends in theself-storage finance business, says, "no glass, no granite." This lackis a blessing because all of the return comes in the form of cash flow and notego satisfaction. While you probably won't hold your daughter's weddingreception in the parking lot of your facility, you will have the cash flow torent the place she really wants.

The curse, however, comes when you sell. Buyers are seldom ever so smittenwith a self-storage facility they forget the numbers. The usual buyer ofself-storage is someone just like you--in it for the money. In almost everycase, the buyer already owns a storage facility, knows the market cap rates andoperating costs, and refuses to overpay. Thus, it is unlikely you will find the"greater fool" who will pay above market cap rates, or thenon-self-storage investor who will take the time and energy to understand theproduct and bid up the price to his own detriment. While we can earn greatreturns as owners, we aren't likely to sell a project on cap rates muchdifferent than those we bought it on--although, from time to time, cap rates dovary.

Sometime in the future, as the market gets better educated on self-storage,we may see these cap rates decline and our selling prices increase. But in themeantime, just enjoy the returns. When someone asks the question, "Mirror,mirror on the wall, what is the fairest real estate investment of themall?" and the mirror provides an accurate reflection, it is likely therewill be a series of bright blue garage doors staring back.

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