By Michael L. McCune
In 1999, we were all so excited about the new millennium that we celebrated a year early. Now that it's the real beginning of the millennium, according to some pundits, it is time to once again polish up our crystal ball and see what is in store for the self-storage real-estate market.
First of all, let's do a review of some things we spent some time prematurely worrying about but that did not take place last year. These issues still demand a watchful eye because they are important to the liquidity of the market and to the values of self- storage facilities.
The economy showed surprising strength for being so late in the long economic expansion. This was despite the best efforts of the Federal Reserve Bank to slow down the economy. The net result is that demand for goods and services--including self- storage--remained strong. However, as the year moved along, the discussion of future a slowdown moved from the category of "if" to the kind of landing, "soft or hard." The impact on values of slacking demand are quite serious in self-storage because a $1 drop in revenues equates to about a $10 or $11 drop in the value of the project. While many people believe our industry is recession-proof, to what degree remains to be seen.
Availability of Financing
Over the past year, there was considerable upheaval in the real-estate finance market. Of course, by now, everyone knows the conduits have either quit the self-storage market altogether, or become so selective as to effectively be out of the market. At the last self-storage convention in 2000, it was interesting that there was not one traditional lender represented. As of this writing, banks were almost alone in their willingness to finance self-storage.
The reality is, however, that financing terms remain really quite attractive in a historical context: modest spreads, low interest rates, relatively long terms and long amortization--all of which is good for an owner refinancing or wanting to sell. The better the financing buyers get, the more they can rationally pay for the project.
While all that sounds good, and it is, we are concerned that with banks being the only lenders closing self-storage loans, the availability of loans may become more difficult in the future. Banks are highly regulated and have been told by the regulator in many cities to reign in their real-estate loans. This means they must "underwrite" any loans with more critical standards and not increase their overall lending levels.
Unfortunately, this could disproportionally impact self-storage because its loans are usually small and more costly to administer than those of other kinds of real estate. They are, therefore, somewhat less attractive to lenders, who have to ration loans to borrowers. Also, if we begin to see some defaults on some self-storage loans, you can bet the banks will back off this category quite rapidly. Bankers are notorious for following each other in and out of markets like self-storage.
The conclusion is that the finance markets are more fragile than they might at first appear. If you are refinancing or contemplating a sale, you may want to expedite the transaction to avoid a change in the liquidity of the finance markets.
The value of self-storage is a function of the net operating income (NOI) and the perceived risk (i.e. capitalization rate or cap rate). Clearly, both elements of that formula are subject to some interpretation. We have seen buyers virtually unwilling to purchase "future projected income," except at very large discounts, if at all. The purchasers have relied on trailing NOI (from the last 12 months) for determining values. The buyers are also more likely to adjust the cash flows for expenses that appear to be too low, such as maintenance costs and management fees. Most are also keenly aware that after a sale, real-estate taxes may increase. They will adjust the cash flows to reflect these additional costs.
Cap rates are always an interesting topic of discussion. Essentially, cap rates are a shorthand way of combining the perceived risk and the expected returns when valuing a property. The lower the cap rate, the higher the price, because to arrive at value you divide the NOI by the cap rate (as a percentage). To compare cap rates between properties, the definition applied to NOI must be the same for each property--and they seldom are. Thus, many discussions of cap rates are not meaningful because they are utilizing two different NOI assumptions.
Often, we see sellers and buyers describe the same transaction with two completely different cap rates, i.e., "I sold at a 9.5 cap rate," and "I bought at a 10.5 rate." To the extent that bragging rights are important, cap rates can accommodate them. With all that said, and assuming the NOI figures are all based on similar definitions, here are some general comments on what is happening in the marketplace to cap rates and what we expect to see in the new year:
- For the highest quality properties in high growth markets and "protected" locations, cap rates will be in the 9.5 to 10.5 range, depending on the area of the country. This applies only to a relatively select group of properties and markets.
- Properties that are not "pristine" in all characteristics receive cap rates from 10.5 up to 12 and even occasionally higher.
A couple years ago, when the REITs were busy acquiring portfolios, cap rates on the best properties were lower, but generally not as low as advertised. The REITs are not as active in buying properties today and, thus, some of the pressure on cap rates is now gone. Cap rates are once again in the general range that has prevailed in the industry for many years. The exception today would be that cap rates on marginal properties tend to be somewhat higher than in the past, but not uniformly so. (To get an idea of the issues that impact cap rates, see the article titled "Cap Rates and Sales Prices" at www.selfstorage.com.)
A Word on Selling
It appears we may anticipate some slowdown in the economy, which will impact self-storage operations to some degree. We foresee the potential for disruptions in the availability of financing for real estate in general, as well as self-storage. As in all economic slowdowns, buyers tend to be more cautious and demanding, making sales of properties more difficult.
A word on selling is appropriate at this point. Well-located, quality self-storage is just about the best real-estate deal around. If you own such a facility, you shouldn't sell just because of an economic slowdown. If you sell, you should have another reason, such as retirement estate planning. If you see such an overriding need to sell in the near future, do it now, otherwise hold on and simply realize the business may not be quite as good as it was the last few years. The advantage is that you don't have to worry about how or when to get back into an ownership position of this great piece of real estate.
Clearly, we can't define the magnitude of all of these possibilities now. They may well be minor or they could be major, but it is prudent to anticipate the potential negatives that may appear. In other words, if you need to refinance your facility, do it now. It may not be the best deal you can ever do in the present, but at least it is a deal that will work well in the future and ensures your ability to keep the property. If you anticipate selling in the intermediate term, now is probably a good time to start the process. The real-estate cycles usually run anywhere from three to five years. So unless you want to wait out the cycle, now is a good time to sell.
Michael L. McCune has been actively involved in commerical 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 nation's 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 or visit www.selfstorage.com.