European lenders and investors, who are unfamiliar with the risks associated with self-storage, might be questioning their investment decisions, given the soft performance recently reported by U.S. storage operators. During the past 24 months, self-storage in the United States has transitioned from a period of increasing rents and high occupancies, through a period of declining rents and lower occupancy, to where it is today, seeking to regain high levels of performance.
Does that mean lenders, investors, developers and others should be concerned about the profitability of self-storage in Europe? Should weak U.S. market conditions be interpreted as a sign that international markets are headed for trouble as well? After all, several European markets are showing signs of weakness as demonstrated by sluggish rental-rate increases and slow lease-up rates.
Market Similarities and Differences
To answer these questions, we need to examine some of the similarities and differences between U.S. markets and those newly developing in Europe. There are more similarities than differences when it comes to things like design, management and the investment opportunity self-storage offers.
While there are many similarities, there is one big difference. Self-storage in the United States has been developing for a much longer period. Thus, the level or intensity of development is greater. Developers in many U.S. markets have all but satisfied the pent-up demand they have been building toward for the past 30 years. Many domestic markets are reaching the point of long-term balance between supply and demand.
In our most recent survey of the nation’s top 30 Metropolitan Statistical Areas (MSAs), the worst occupancy reported was in the low-80 percent range. It is important to note the current operating performance of U.S. facilities only reflects but one more phase this young industry must transition through on its way to maturity. When compared to the cycles that retail, office and industrial properties experience, this down cycle for self-storage has been pretty mild.
The European self-storage industry has just begun its journey toward satisfying the pent-up demand for space that took the United States more than 30 years to satisfy. In many European markets, there are millions of people and only a handful of facilities to meet the demand for storage, a demand that is growing daily. Some European developers would have you believe the markets are already overbuilt. The truth is, however, they are far from reaching their long-term level of market stability.
Individual U.S. markets went though many cycles of overbuilding on their way to the point of long-term balance. The current softness in some European markets only reflects overzealous developers who were too eager to supply space faster than demand warranted. International markets take time to develop because the public has to become aware of the benefits of using self-storage. As the public’s awareness rises, the existing supply will be absorbed, just as it was in the States.
Facilities in markets that do become temporarily overbuilt are very seldom, if ever, at risk of being unprofitable or threatened with foreclosure. That assumes, of course, developers do not forget their common sense. They must also remember, to be profitable in the long run, it takes a well-located, properly designed facility that has professional management and is not over financed.
Weak Performance, Strong Investor Demand
There are good reasons investor demand for self-storage has been so high lately, despite soft performance. Remember, self-storage is not the only type of U.S. real estate to post lackluster operating performance over the past two to three years. Virtually every type of commercial or industrial property has experienced increasing vacancy rates and decreasing rental rates during this period.
At the same time, the stock market’s performance did not offer much opportunity; thus, investors have turned to real estate—specifically self-storage, because it is still among the most profitable investments. Access to an abundance of cheap debt, together with plentiful equity and mezzanine capital, has driven self-storage sales prices to their highest levels in history.
At the same time, lenders have continued to demonstrate their confidence in self-storage by their continued willingness to lend capital at the lowest rates in history. In many cases, interest rates on long-term self-storage loans have been lower than 6 percent. These fully amortizing, 25-year mortgages typically have five-to seven-year calls, with loan amounts up to 75 percent of value. Variable-rate instruments have even lower interest rates and similar terms.
National Investment Parameters
Following is a summary of national investment parameters derived from a large sample of self-storage sales across the United States during the periods indicated.
There has been strong competition to buy the few existing facilities on the market lately. Thus, cap rates on some recent transfers have been at historical lows. It is not uncommon for portfolios to receive several bids from potential buyers. Often, the sellers go back for a second round of bidding before selecting the most qualified buyer offering the best price. The investor market in Europe will, one day, reach the same point of competitiveness.
At the time of this writing, an institutional investor is purchasing a portfolio of more than 30 facilities. The purchase price reflects a trailing cap rate in the low-8 percent range. Another, smaller portfolio is transferring based on a trailing cap rate of less than 8 percent. An individual investor, long familiar with self-storage, recently purchased several facilities in the Southwest based on a trailing cap rate that was less than 7.5 percent.
In many cases, the prices being paid for these portfolios, as well as individual facilities, reflect a large premium over replacement costs. The justification offered is the barriers to entry are becoming higher and higher. As development continues, cities start to become concerned about overbuilding. Some have even passed ordinances prohibiting new self-storage development, and others have passed moratoriums. The European markets are far from reaching the point where cities should become concerned about overbuilding. Why, then, should European investors or lenders be concerned today, when the risk of long-term overbuilding is so far into the future?
Risk: United States vs. Europe
The value of real estate, whether here in the United States or in Europe, is calculated the same way. It is based on the present worth of the future benefits, i.e., the cash flows. Thus, the risk associated with an investment must properly measure the likelihood the cash flow will continue beyond the term of ownership.
For years, there was a “perceived” risk of U.S. self-storage that kept lenders from lending, and helped to keep overbuilding under control. Investors typically added 50 to 100 basis points to cap rates to reflect this perceived risk. Today, that premium on the cap rate is gone. Lenders and investors in the States understand this investment vehicle; and it is only a matter of time until European lenders and investors understand it also.
Considering the intensity of development of self-storage in the United States and the high level of rental rates and occupancies facilities have sustained, one can only conclude real opportunities exist in the European markets. European lenders’ lack of familiarity with self-storage is a negative and a positive. It’s a negative because developers trying to find construction financing will soon learn it is not only hard to find, but very expensive when and if they do find it. It is a positive because it puts a lid on how much is built, and controls overbuilding to some degree.
The real opportunity, therefore, will be for equity developers who understand selfstorage. Their goal will be to develop as much as they can, as fast as they can, before everyone else wakes up to an opportunity that comes but once in a lifetime.
Charles Ray Wilson is the owner of Charles R. Wilson & Associates Inc., an appraisal firm that specializes in self-storage valuation nationwide. He is also owner of Self Storage Data Services Inc. (SSDS), a research firm that maintains a database of more then 40,000 self-storage facilities and tracks operating performance. For more information, call 626.792.2107 or visit www.crwilson.com.