Mirror, Mirror on the WallWhat is the fairest real estate investment of them all?
By Michael L. McCune
This article represents the inauguration of a new series of monthly articles for Inside Self-Storage dedicated to the real estate market. In the future, this column will offer a dialogue with industry experts on the state of the self-storage and real estate markets. Twice each year, our experts will focus on each of five regions and national trends. However, we thought we would kick off the roundup with an article on why self-storage is such a great real estate investment. This article previously appeared, in part, in the Market Monitor 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 going on with real estate in that region.
The self-storage industry has grown up over the last quarter century. In the not too distant past, everyone in the real estate business thought those little "tin" buildings just couldn't be worth much--and they certainly weren't very pretty. The institutional-type investors much preferred to run the boss out to a new luxury hotel or mega-mall and say, "Look at what we just bought!" As they were getting they're picture taken with the trophy project, they thought about how great the picture would look in the annual report. Meanwhile, the lowly self-storage developer was sitting at his kitchen table with pencil and calculator in hand saying something like, "Gee, these numbers sure look good." Slowly but surely, some of the real estate gurus began to catch on--after they stored some of their junk at a self-storage facility, did a quick calculation of the rent per square foot and estimated the costs.
During our rather brief history in the self-storage business, perceptions have changed somewhat, but not dramatically. The facilities look better, but no one calls even the best self-storage facility a "trophy." Wall Street endorsed 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 thought self-storage should be included in portfolios of real estate loans, but that concept, too, has now faded to near extinction.
A Hidden Beauty Is Found
Despite mainstream real estate investors continuing to yawn about the self-storage business, I thought we might explore the reasons they overlook the best of all real estate investments. Having kicked around the real estate business for the last 30 years--and having worked with just about every type of property: office, hotel, industrial and retail--I am prepared to make an argument that self-storage may well be the best type of investment you can make in the real estate world. It is the "Snow White" of real estate--a real 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- conceived self-storage are better than those of other types of real estate. I must warn you, however, my "mirror on the wall" only reflects certain attributes, such as product-demand growth, cash flow, return on equity, break-even risk, additional capital costs and other mundane numbers. If you'd like the mirror to reflect more subjective criteria--such as annual-report picture value or suitability of a property as a location for your daughter's coming-out party--my mirror probably will not suit you. So for the balance of this article, I am going to make several arguments about the relative merits of self-storage investments compared to other types of real estate. Let's see how this reflection compares and see if we think, like the Prince, we have indeed found Snow White.
It Is a Growth Industry
One significant factor makes self-storage a better bet in the long run than a lot of other real estate types: Its market is growing faster than the population. First, only about one-third of Americans have ever used self-storage. Second, after a period of time--say five years--many self-storage facilities report most of their business--say 80 percent--is from repeat customers. If you look at what these statements mean, it is clear customers are not only discovering self-storage but, more important, they are learning to use it repeatedly. The point is, the growth of self-storage is not limited to the population growth in a market. It gets a great boost from "moving up the learning curve" of the consumer.
Icing on the Cake?
There is one other factor that probably impacts growth demand but is harder to 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 not very useful or profitable. Self-storage, on the other hand, thrives on our fast-growing accumulation of stuff and our emotional attachment to it.
To get a perspective on the potential for self-storage in our society, just think of all the things you are saving for your children vs. what your parents saved for you. This is to say nothing of your own "toys" you can't bear to part with but need a resting place. The net result is the demand for self- storage is growing very rapidly and in excess of the rate of population growth--at least for the time being. We also know that fast growth in demand covers a lot of sins in real estate, but it also enhances our ability to earn greater 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 to self-storage rents over the past 25 years. Despite the fact the industry built approximately 30,000 facilities in that general time frame, rents have continued to go up, proving the total demand has exceeded the supply and the population growth. 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 of supply in such a short time, the story is truly remarkable.
I am now going to explain five reasons the cash flow on self-storage is higher--and probably more secure--than on other kinds of real estate. This translates to higher returns on your investment, less risk and possibly higher prices. All of my arguments are based on the assumption a facility is well-maintained, in a good location and in a rational market (i.e., one that is not overbuilt). Remember: Even though we believe self-storage is the best real estate investment, this doesn't mean it will bail out "dumb deals."
Zoning. We all know that securing zoning for self-storage is becoming more difficult in almost every community. It is not that self-storage is 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. What planning commission in its right mind would ever approve a project that had no glamour and didn't produce a lot of taxes? This, of course, tends to restrict additional development and increase cash returns of existing facilities as demand builds. If you have a good facility, it is increasingly likely the local zoning board will not jump through hoops to help developers build potential competition.
Cap rates. In Chart 1 (compliments of Ray Wilson of Charles Ray Wilson & Associates), you'll see some national averages of cap rates on competing real estate types. A cap rate is really the annual return you can expect 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 most other real estate types. At first glance this looks like only a "so what" difference, but closer examination shows self-storage will yield 10 percent to 20 percent more in annual cash for the same dollar of purchase price.
Overall Capitalization Rates
|Source: Self Storage Data Services Inc. and Real Estate Research Corp.|
If you leverage your self-storage investment (i.e., get a mortgage), the difference in cash-on-cash returns becomes truly impressive. For example, compare a self-storage facility at a 10 cap rate and another real estate investment with the same net operating income at an 8.5 cap rate. The cash-on-cash return on the self-storage is 13.4 percent vs. 7.4 percent on the other investment (see Chart 2).
Comparison of Cap Rates
|Net Operating Income||$100,000||$100,000|
|Loan at 75 percent loan-to-value||$882,000||$750,000|
|Return on Investment||7.4%||13.4%|
|Source: Self Storage Data Services Inc. and Real Estate Research Corp.|
Capital risks. Often times, investors for other types of real estate overlook the requirement (and risk) for additional capital. Hotels always need new furnishing and redecorating; office buildings require massive amounts of tenant finish and commissions; apartments need everything and often. (If you would like some detailed comparisons, drop me an e-mail and I will send you some startling 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 every three months! While this comment is somewhat facetious, the capital demands of a self-storage facility are very small, not only in relative terms to other real estate, but also in absolute terms.
Operating costs. Once again, self- storage appears to have an advantage because the operating costs for self-storage usually have only a small exposure to volatile energy costs and labor. Many other real estate types have as 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 expense components, the risk for self- storage is reduced and the consistency of income is 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 the self-storage finance business, says, "no glass, no granite." This lack is a blessing because all of the return comes in the form of cash flow and not ego satisfaction. While you probably won't hold your daughter's wedding reception in the parking lot of your facility, you will have the cash flow to rent the place she really wants.
The curse, however, comes when you sell. Buyers are seldom ever so smitten with a self-storage facility they forget the numbers. The usual buyer of self-storage is someone just like you--in it for the money. In almost every case, the buyer already owns a storage facility, knows the market cap rates and operating costs, and refuses to overpay. Thus, it is unlikely you will find the "greater fool" who will pay above market cap rates, or the non-self-storage investor who will take the time and energy to understand the product and bid up the price to his own detriment. While we can earn great returns as owners, we aren't likely to sell a project on cap rates much different than those we bought it on--although, from time to time, cap rates do vary.
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 the meantime, just enjoy the returns. When someone asks the question, "Mirror, mirror on the wall, what is the fairest real estate investment of them all?" and the mirror provides an accurate reflection, it is likely there will be a series of bright blue garage doors staring back.
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.