This month, I gathered a roundtable of experts to discuss the state of self-storage in the southern United States. Let's hear what local experts have to say about their respective cities and regions. Our panel of brokers includes: C. William Barnhill, Omega Properties, Mobile, Ala.; Dale C. Eisenman, Midcoast Properties Inc., Hilton Head Island, S.C.; Mark D. Keys, Cornerstone Realty, San Antonio; Richard Minker and Tyler Trahant, The Richard D. Minker Co., Fort Worth, Texas; and Frost Weaver, Weaver Realty Group Inc., Jacksonville, Fla. Because of the unique economic times in which we find ourselves, I have contributed comments on the national market as well.
WHAT IS THE RANGE OF CAP RATES IN YOUR MARKET? WHAT DETERMINES THE DIFFERENCE?
Barnhill: Cap rates in our market range from 10 percent for larger upscale properties to 11percent to 12 percent for smaller, older properties. The cap rates vary according to size, location and other features of the property as well as the size of the city in which they are located.
Eisenman: Cap rates in this market range from 10 percent to 11 percent on trailing income--unless there is a clear reason, in the buyer's mind, to use pro forma income, such as additional rentable square feet, land not included in the net operating income, or some other factor that creates additional value.
Keys: Cap rates are now generally running between 9 percent and 11 percent based on the past year's historical performance for stabilized facilities. What determines the difference is largely the buyer's perception of the income stability and potential upside the investment offers. Newer facilities with appealing features situated in prime locations with barriers to competitive entry are commanding the highest prices and, conversely, the lowest cap rates. Older, less functional properties are more difficult to keep leased and more expensive to maintain. Buyers recognize this and require a higher cap rate to "risk adjust" their investment.
Minker/Trahant: We are currently seeing cap rates in the range of 10 percent to 13.5 percent. The lower cap rates are for class-A facilities with strong stabilized occupancy. The higher cap rates reflect either underperforming new properties or older properties with lower occupancy rates. Mid-range cap rates are for newer properties with moderate occupancy and future lease-up potential. There are some buyers who will pay 9 percent-plus cap rates--but on actual income not pro forma--for class-A-type properties.
Weaver: Cap rates on listed properties have fallen as low as 9 percent on properties of marginal quality for several reasons. First, some brokers are very aggressive in trying to get listings and will represent to an owner a higher price than is obtainable in the market. Second, due to lower interest rates for financing, leverage returns are higher, giving a justification for a lower overall cap rate on quality properties. Finally, due to the fact there are not a lot of quality properties on the market at this time, owners believe the supply-and-demand factor justifies lower cap rates. While there is certainly some justification for this, in theory, I don't see transactions being consummated at these lower rates. Recent transactions have still been in the 10 percent cap range for quality properties and higher cap rates for the smaller owner/operator properties.
Weaver makes a great point when he suggests many properties are listed at higher prices than market because the broker is simply "buying" the listing with the promise of a higher price than market and hoping that the seller will capitulate on the price as the true market value unfolds. As beguiling as the promise of an unrealistic price is, the result is often that sellers miss potential sales to serious buyers, thus missing the great "market" sale that exists at today's market cap rates. It is shame to see sellers miss a good market because they are induced into a listing on false expectations.
IS OVERBUILDING BECOMING A SIGNIFICANT FACTOR IN YOUR MARKET? DESCRIBE THE CURRENT SITUATION.
Barnhill: Overbuilding has been and continues to be a significant factor in our market. Developers continue to add product even in markets that are not fully absorbed with existing product. I do see most banks are demanding more due diligence, and even a feasibility study in some cases.
Eisenman: Like everywhere, there are pockets of overbuilding or, as I like to say, "capacity well-positioned for the future."
Keys: Overbuilding is a significant factor in the Texas market, but it is spotty rather than epidemic. Developers are still managing to identify pockets of demand and build profitably. Yet there are facilities that have been open for two years and are only 50 percent leased. Overall, the pace of new construction in the market has outpaced absorption for the last several years. And with the current economic downturn, facility owners across the board are starting to feel the effect all this new space has on the market.
Minker/Trahant: Overbuilding is continuing to become a bigger factor in the overall market, but it is not yet a significant factor except in selected geographic areas. In North Texas, those markets appear to be in North Fort Worth, South Arlington/Mansfield and North Dallas/Plano/Frisco.
Weaver: Overbuilding is a significant factor in the urban market areas. Due to a lack of quality product for sale, many investors that would acquire existing properties are now looking to buy land and build. The economics look good on paper, and banks are still willing to lend. There are still several inherent factors that are affecting the lack of product available for sale. If a seller cashes out, there are few attractive investment alternatives. Interest rates are still very low and the stock market is still very volatile. There is a lack of quality product available for 1031 purposes, even in other types of real estate. In general, retail and industrial properties are very hard to find, and while there are numerous office properties for sale, there is a high vacancy factor statewide.
The comments our brokers provide on overbuilding are generally true across the country. While the problems are currently somewhat isolated to specific markets, the trend is to entire cities being overbuilt. However, a major problem is our industry does not have information available to determine the exact extent of the problem. All other categories of real estate keep track of such statistics, thus enabling lenders and developers to moderate the development plans prior to a major overbuilding. Obtaining this information should be the highest priority of the national and local associations, as not having it harms every owner in a market. Right now, with low interest rates making investments (i.e., development) particularly attractive and no reliable information to dissuade them, developers are going to continue developing--it's what they do! Market surveys and feasibility studies are a must.
ARE OCCUPANCIES DECLINING AND RENTAL RATES DECREASING? WHY?
Barnhill: Well-run properties are maintaining occupancies. However, older properties that are poorly managed are losing ground. Effective rental rates have declined somewhat due to the rental discounts offered by most facilities.
Eisenman: There are some signs that rentals are picking up or becoming more stable after a soft December and January. The weak economy, seasonal trends and overbuilding make an analysis of the relative causes of market softness difficult to isolate, but it certainly appears they are all contributing factors. It is likely overbuilding will turn out to be the most significant cause and will have the longest effect on rates and occupancies.
Keys: Overall occupancies have declined in the major Texas markets, as well as in some secondary markets when you take into account new facilities in lease-up. New facilities often offer rental discounts to encourage a quick lease-up, which has the effect of depressing the overall market rental rates. Still, many properties have managed to maintain their occupancy and income despite the effect of new competition and a softening economy. Storage facilities have fared better than other types of income properties during the current downturn. Both are favorable indicators for the industry as a whole.
Minker/Trahant: Occupancies are declining pretty much across the board. In some selected markets and/or facilities, some of those declines are significant where extensive new development is taking place. Self-storage operators are attributing the decline to the overall state of the economy, job loss, etc., and the mindset since Sept. 11 from which they have never fully recovered. As to rates, we are seeing very limited or small rate increases. Most owners are pleased to be able to hold their current rates, but many are discounting to match the deals offered by newly opened or slower leasing facilities.
Weaver: There is a trend of declining occupancies in the major cities due to continued building and oversupply. In the smaller markets, occupancies remain strong, with rental rates stable of increasing. In the major markets, published rates have not been decreasing, except in certain market areas; but there is a trend toward concessions as an inducement to the consumer.
WHAT TYPE OF FINANCING IS AVAILABLE FOR FIRST-TIME BUYERS?
Barnhill: Local bank financing is the predominate method available for local properties. Refinancing is usually with a 15- to 20-year amortization and a five-year balloon payment fixed for five years at 6.5 percent to 7 percent. Variable rate loans are at least 250 to 350 basis points over one-month LIBOR, or prime plus 1 percent. For first time buyers, the equity requirement is 25 percent to 30 percent, and the underwriting requirements are quite stringent unless the owner is very strong financially and has a good banking relationship. Additionally, the debt-coverage rate is about 1.30.
Eisenman: Local banks are willing to finance self-storage buyers based on normal credit underwriting. Banks with existing loans for self-storage may be the best sources for the first-time buyer. If one is buying an existing facility, he should explore financing with the existing loan holder. The first-time buyer should strongly consider hiring existing management or using a professional third-party manager, which will demonstrate to the lender a greater likelihood of success and loan repayment.
Keys: First-time buyers may find favorable financing with a local bank or conduit lender. Currently, a first-time buyer can expect a 70 percent to 75 percent loan on a 15- to 25-year amortization, due in five to 10 years. Interest rates have been running in the 6 percent to 7 percent range. Most lenders want a debt-service coverage ratio of 1.3 or better. These are broad parameters; the actual terms a buyer can achieve will depend on the facility being purchased and the buyer's credit worthiness.
Weaver: There is financing available for first-time buyers, provided they have decent credit and general business experience. This financing is generally available from local banks that know their markets and the property being acquired. The local banks have money to lend and understand the favorable economics of self-storage facilities. I have recently had local banks contact me regarding their interest in lending on self-storage facilities.
WHAT IS THE STATUS OF FINANCING FOR EXPERIENCED BUYERS?
Barnhill: Experienced buyers can command five-year money at 5.5 percent to 6.5 percent with a 15- to 20-year amortization. The equity requirement is usually about 20 percent to 25 percent, providing the debt-coverage rate is at least 1.20 to 1.25. Some experienced buyers in our area have opted for variable-rate bond financing with LIBOR rates. The overall effective interest rate is currently about 3 percent floating with LIBOR. These loans usually have a 20-year amortization with a five-year balloon.
Eisenman: Experienced operators with a proven track record will have an easier time securing financing. While rates are low, underwriting is becoming more conservative, so an experienced operator who can demonstrate past success in self-storage will find banks more receptive than one who cannot.
Keys: Experienced buyers are finding financing in essentially the same places, as well as with regional banks with which they have established a lending relationship. These buyers can often obtain financing on so-called "value-add" facilities--those that have not achieved a stabilized occupancy level--much more readily than a first-time buyer. For the experienced buyer, the operational history of a facility and debt-service coverage ratio may be less critical.
Weaver: The local bank is also a very viable source for the experienced buyer, but other options are available to him in the national lending market, including banks, insurance companies and conduit lenders. I was recently contacted by a regional bank interested in self-storage loans in Florida. At this point, financing does not appear to be a limiting factor in self-storage transactions or development. However, the favorable economics of self-storage development and the lower perceived risk is increasing supply at a faster rate than absorption. This is increasing supply to a precarious level in many selected markets, leading to higher risks for the developers and lenders and lower returns for the investors.
As can be seen from our Brokers' comments, the availability of loans at great, historically low rates means buyers can get a terrific cash-on-cash return and sellers can get the best market price in years. The dark side is development will continue and could cause serious problems for individual properties. This suggests two strategies: 1) if you are going to be a seller in the next couple of years, now is the time, before interest rates go up and occupancies go down; and 2) if you don't plan to sell, make sure you have refinanced and lowered your debt-service costs so you can compete in a difficult market.
Michael L. McCune has been actively involved in commercial 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.