By Aaron A. Swerdlin and H. Dan Miller

The last three to four years have been very exciting for theself-storage industry. Since June of 1994, more than $1.5 billionin self-storage properties have changed hands--a volume theindustry has never before seen. Will this level of activitycontinue? More importantly, what can the industry do to insurethat this high level of activity continues?

Obviously, the REITs (real estate investment trusts) are thekey ingredients to maintaining a $5 million per-yearconsolidation volume (they have been involved in more than 75percent of the ownership changes in the last three years).Therefore, in order to understand what will keep this volumegoing, we must understand the REITs and their motivations.

REITs are companies whose sole business is buying, developingand operating real estate. REITs have been in existence for manyyears. Most REITs are publicly traded on one of the stockexchanges, which means that the ownership of the company isdistributed among several million shares and several thousandshareholders. Between 92 percent and 95 percent of the profitthat the company generates is passed to the shareholders throughdividends. The REIT itself does not pay income tax on its profit,because along with the income, the tax burden is also passed toits shareholders (the shareholders simply pay income tax on thedividend income). The per-share price of a REIT stock is usuallydirectly related to its dividend, which makes REIT stocks muchlike bonds and utility stocks. In today's financial climate, REITinvestors look for a REIT stock to yield between 5.5 percent and7.5 percent, depending on the overall strength of the company.About 250 REITs are publicly traded on one of the stockexchanges. Of the 250 or so REITs, five focus solely onself-storage properties.

There are several reasons why the publicly traded storageREITs (Public Storage, Storage USA, Sovran Self Storage, StorageTrust and Shurgard Self Storage) are acquiring as many propertiesas they can. As Wall Street is investing money in theself-storage REITs, the REITs will continue buying. Wall Streetwill continue investing in the self-storage REITs as long as twoelements exist: strong financial performance from theself-storage REITs and a bullish stock market. If either of thesetwo elements cease to exist, the optimism that has fueled thebuying frenzy will become more cautious and probably slow down.

How do the REITs continue to post strong, quarterlyperformance? It's quite simple: Grow FFO (funds from operation),grow occupancy, grow revenue and grow the asset base(acquisitions). So far, the REITs have consistently posted stronggrowth numbers. For example, Storage USA has more than quadrupledin size since its IPO (initial public offering) and Storage Trustwas one of Money Magazine's top ten performing REITs of1996.

The main reason REITs have performed so well is supply/demandratios have favored owners, a trend that is beginning to change.Real-estate investors are constantly searching for a competitiveadvantage. Many local and national apartment, office and retailinvestors are acting on the self-storage REITs' success anddiversifying their portfolios by developing new self-storageprojects. The problem is, many of these developers have adoptedthe motto, "Build It and They Will Come." Obviously itis not that simple.

The key to a successful site depends, in large part, onsupply/demand ratios. Too many sites that have been built or inthe planning stages, are going to simply distribute the samenumber of renters among more units, an equation that leads onlyto occupancy and revenue declines. The best way to ruin, or atleast slow down the momentum, is to begin to overbuild themarketplace. Long-term, excessive building only benefits theREITs as they will come into overbuilt markets and buy thedistressed deals after the banks take them back (like manyinvestors did in the early '90s). Short-term, overbuilding hurtseveryone.

Interest rates are the second ingredient to the recent successformula. Sellers have been amenable to selling because cap ratesare as aggressive as ever. The only reason cap rates are so lowis interest rates are low. If a company borrows money at 7.75percent and requires a 300 basis-point (3 percent) spread betweenthe cost of debt (the interest rate) and the return oninvestment, then the target cap rate is going to be 10.75percent. The companies require a spread between the return andthe cost of funds because they have dividends to pay, operatingexpenses to absorb, etc. If their interest rate goes to 8.5percent, the cap rate goes to 11.5 percent because the company isstill going to require a 300 basis-point spread. The cap rate issimply going to increase accordingly. What does this mean to theowner of a $2 million property? If a property generates $250,000in NOI at a 10.75 percent cap rate, it would be worth $2,325,581.At an 11.5 percent cap rate, the value would be $2,173,913, adifference of more than $150,000 from just a 1 percent change ininterest rates. Imagine what would happen if interest ratesincrease 3 percent or 4 percent.

In my opinion, the activity level we have seen during the lastthree years is not going to continue, but I think the level ofdecline will be market-specific--more in some markets, verylittle in others. Why? Banks are loaning construction money ondeals that shouldn't be built, which results in overbuilding andunfavorable supply/demand ratios. What can we do, as an industry,to continue to build momentum and not stunt it? Cautiousoptimism. The industry is still very strong, and there are fewindicators suggesting any substantial change ahead. Therecontinues to be a tremendous amount of opportunity to capitalizeon the success of the industry. The secret: Be strategic. Theresale market is very active right now, but it's not going tostay that way forever.

If selling a property is in your future, the self-storageREITs are, and will continue to be, the most logical buyers inmost markets, because of their availability of capital andaggressive acquisition strategies. They can afford to pay morefor most properties than an individual buyer or private company.One of the secrets to realizing the full value of a property isthe manner in which it is marketed to the REITs. A real-estatebroker is vital to an effective marketing campaign. Real-estatebrokers are not getting paid to know who the buyers are. They aregetting paid to manage the sensitive process of marketing theproperty and implementing a very methodical, property-specificplan.

What does this mean to the average self-storage owner? It alldepends on your motivation. If you are going to be a selleranytime during the next five years, now is the time to at leasttest the waters. Sales prices haven't been higher than they aretoday, so if nothing else, marketing your property is a freeappraisal.

Key indicators that your market is about to begin to"soften" include the following:

The industry is going to continue to evolve and become moresophisticated, which will benefit everyone. During the nextcouple of years another $1 billion worth of acquisitions willoccur. With the various ways to structure cash and tax-deferredsales, it is an appropriate time to consider all options. So,what can the industry do to insure that this high level ofactivity continues? Don't let the high-activity level drivedecisions. Let the decisions drive the activity level.

Aaron A. Swerdlin and H. Dan Miller are spearheading the CBCommercial Self Storage Advisory Team, a team of CB CommercialReal Estate professionals focused solely on the real-estate needsof the self-storage industry. Mr. Swerdlin is the former directorof acquisitions for Storage Trust, one of the five self-storageREITs. Together, Mr. Swerdlin and Mr. Miller have been involvedin the acquisition and disposition of more than $220 million inself-storage property. They can be reached by calling the Houstonoffice of CB Commercial at (713) 840-6500.