It's that time of year when our dedication to new year's resolutions is safely behind us and we are free to think about things really happening in our lives. March also brings the winds of spring, which are the perfect metaphor for understanding where the self-storage industry and our own investments are going. Perhaps we should pause for about 15 minutes and see if we can get an idea from which direction the winds have come in the past.
For the last couple of years, the winds of fortune have been coming from the cold north of recession. While the self-storage business is more resilient than most, the recession has had an impact. There has been significant pressure on rental rates and occupancies as many customers have found storing their "valuables" is no longer within their budget. In fact, many are comparing their valuable possessions to the rent of the storage facility and coming to the conclusion they are paying a lot to store very little. Many renters have decided they are simply paying for the privilege not to decide to throw stuff away.
Customers have become very value- conscious--the service and cost equation has become more important. There seems to be a trend in consumers' thinking that it is their duty to shop around and find the greatest value. Some owners will argue price is the greatest objective and others will argue quality and service count the most. Both will be right in some measure. Renters will find the right balance for themselves between price and product, but you can be sure they will be considering both aspects of the bargain. However, in times of economic distress, or the recent memory of such times, price more often seems to be the ultimate taskmaster in this selection process.
Thus, while the winds of the recession may well be changing direction, the howl of those cold winds will echo in the ears of the consumer for a while longer and force them to make the value calculation in selecting their storage facility. It is important to ensure your rents are competitive and your service and maintenance are top-notch. Price increases are unlikely to be well tolerated for some time into the future, as a couple of the major operators have found out by having to roll back increases they had come to believe were part of their birth right.
It is also clear the winds brought a mixed blessing in the form of the lowest interest rates in 40 years. For those who refinanced, it was like a gift from heaven--cash flow soared up and everyone felt very smart. The grace of lower interest rates has often covered up some market weakness and operational sloppiness. Not only did cash flows go up, values of properties increased as they became easier to sell, and buyers became intrigued with the higher cash-on-cash returns available. Folks who had been in the stock market found cash flow is more valuable than Wall Street analysts' promises of future gains in share prices.
All in all, it's a very nice time to be a seller--or a buyer for that matter--getting the great cash-on-cash return. However, all investors are very concerned about the quality of what they are buying. Their recent experience has taught them to do more due diligence and make sure they are buying real cash flow, not a promise and a story. Thus, buyers, while more desirous of owning self-storage facilities, are also much more careful and critical of the quality and risks attendant to the projects. In other words, they are just like our rental customers--hypersensitive to real value.
Despite the warmth of the low-interest winds, there were (and are) some nasty gusts that came along with them. These gusts are represented by local pockets of moderate and severe overbuilding. The low interest rates created zeal on the part of developers and, worse yet, would-be developers to build projects without regard to market demand or other feasibility information. The full extent of the overbuilding has not become apparent as many projects are still in the pipeline and not yet true competitors.
Overbuilding has always been the Achilles' heel of the self-storage business, and it is almost always the unsophisticated developer who causes the overbuilding in a specific market. While the effects of recession certainly compound the problem, it is overbuilding that continues to have the most devastating impact on self-storage operations. When this tornado blows in, there can be severe damage to all current participants in the market.
It is worth thinking about what a little overbuilding can do to a market. Understanding the math can provide very useful insight into decisions that will impact a facility. For example, let's assume a well-established market area with a five-mile radius has five facilities of about 40,000 square feet each (200,000 square feet total). This comfortable little market has suffered modestly from the recession, and average occupancies are down from 92 percent to 85 percent. This means the actual market demand is about 170,000 square feet (200,000x.85). All of the owners are disappointed at the occupancy numbers, but quite sanguine the market will soon recover.
However, a fellow just bought a failed lumber yard in the area and has gotten approval to build a self-storage facility. He was enticed by the low interest rates the bank offered him on a mini-perm loan. His calculations indicated a breakeven point at 62 percent occupancy. His plans call for phase I to be 50,000 square feet and phase II to be 35,000 square feet. Because the site is relatively high profile in the city, the planners have insisted it have all the bells and whistles of modern self-storage facilities.
The addition of phase I to this highly competitive project will bring the total supply of the area to 250,000 square feet; but the total actual demand will remain at 170,000 square feet. This creates an average market occupancy of 68 percent (170,000/250,000). If the new competitor decides to build phase II, the average occupancy will drop to 60 percent (170,000/285,000). It is clear the wind of enthusiasm for building self-storage has carried in a tumbleweed!
Some more math will tell us how much growth will have to occur to resuscitate the market's average occupancy. For the market to have an average occupancy rate of 85 percent, demand would have to grow 42,500 square feet to 212,500 (250,000x.85) or a whopping 25 percent. To get back to 92 percent occupancy, demand would have to grow 35 percent. Few established markets have the short-term potential for such growth.
If you assume the average tenure of the self-storage renter in this market is 12 months, the five original facilities will have to compete with the new operator for at least a year. Remember, his breakeven occupancy is only 62 percent and his first objective is to fill up so he can build phase II. It is likely, given his situation, he will bring lower competitive rental rates to the market to facilitate his lease-up.
If the gust of overbuilding wind blows your way, you may have a different view of low interest rates. It is unlikely the recent weather patterns will change much in the near future. If the recession does end, the memory will linger for some time and cause renters to continue to be very sensitive to value and resistant to rate increases. While falling interest rates may diminish in the near term, they will remain attractive to investors, and the enthusiasm of developers is likely to remain unabated. Remember, it only takes one ill-conceived project to do real damage to an entire market. It will also take the current pipeline about 18 months to empty out, even if we assume no other starts.
Thus, having worn out the metaphor, the only suggestion I can offer for protection from the winds is to wear your coat. In other words, make sure your facility and operations are sharp. Also be sure you have refinanced at these low rates. It could improve your bottom line or give you the margin you need to be competitive if the wind drops the overbuilding tumbleweed in your backyard.
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.