In this industry, we tend to forget we are actually part of two businesses: self-storage and real estate. When self-storage was relatively new, supplies were limited and customers were just learning to use it. Demand was seemingly infinite, and almost no projects failed. Real estate came into play only when the land was bought, or in the unlikely circumstance the property was sold. There always seemed to be a market for a good project, and because the underlying business was strong, a sale generally created a nice profit for the seller.
Starting in the late 1990s, things got even better—well, maybe not all better. Business was still good, even though rental rates weren’t rising as quickly as in the past and vacancies were no longer just “seasonal.” It was clear something in the real estate world was helping—facility sale prices were rising dramatically. As it turns out, the increase was not exclusive to self-storage but across the board in commercial real estate. The cause was falling interest rates.
Prices shot up, but the returns were so wonderful that the demand for real estate radically increased. In search of income-producing property, investors of all types began to actively pursue self-storage facilities. For the first time, our product became truly integrated into the real estate arena. Facility value went up by at least 20 percent, just because of increases in the assessment of income. Obviously, the swell in prices had a dramatic impact on owners’ equity. We learned something from real estate: Low interest rates are not only good for the bottom line, they really take selling prices to a higher level.
Driving the Business
So far, the convergence of self-storage and real estate has been quite satisfying. Property prices are up, and operating costs after debt service are down. But each business has its own cycle. While self-storage is driven largely by product demand, real estate is more affected by interest rates.
There are some other drivers that may double back and haunt the self-storage industry. The most important is the role of low interest rates and high real estate values in creating a situation of overbuilding. Developers’ motivation to build is often a curious mix of uninformed optimism, availability of low-cost money (almost always “other people’s” money), and what appears to be great selling prices. A study of actual self-storage demand is usually never done or done only to satisfy the lender.
Whether or not a professional usage study is conducted, a developer seldom believes one that indicates low demand. He claims the analyst was too conservative and finds another who has a more favorable opinion. Thus, with the push for development the real estate cycle can provide, a market can become saturated in relatively short order.
Understanding Supply and Demand
To understand the natural cycle of the self-storage business, we must also look at supply vs. demand from an operator’s perspective. Demand is not as well understood for self-storage as it is for other types of real estate. This is because most other real estate demand is related to population and income. (It takes people to rent an apartment or office, and they need income to shop retail.) If you know those factors, you can project demand with some confidence.
Self-storage demand, however, has many generators, and none of them has a long history. You could look at population—after all, it takes people to put stuff in storage. But one person might rent three units for a year, while another rents one for three months. One person doesn’t need storage because he has a basement; another needs a unit because his basement is full.
The fact is self-storage demand is hard to predict. The Self Storage Association has commissioned some studies that may help us better understand it. There are also some independent industry experts who have done interesting and useful work in this area, and they are beginning to get a realistic range on demand. But our knowledge of what drives self-storage use is still limited, even with the sophisticated tools available for projecting demand in other industries.
What We Know
Without an accurate forecast of demand, it is difficult to predict the performance of existing selfstorage facilities. It is even more difficult to get a good measure on new sites being built. Let’s summarize what we do know.
With isolated exceptions, rental rates have not increased much, and there have even been some dramatic declines. Vacancies have increased, and few facilities are actually full (95 percent occupancy or higher). These factors indicate demand is flagging in light of increasing supply. While it may be rightly argued that the slowdown in the economy is causing the problem, it is not at all clear that this is enough to overcome the high cycle of development, particularly in some markets.
The market for commercial real estate continues to value all kinds of properties at almost record values. Interest rates are moving up, as the Federal Reserve has raised rates five consecutive times. However, investors actively seek opportunities in which they can lock in a low interest rate and get a good property. Even though prices are at all-time highs, the leveraged rates of cashon- cash return are also high (12 percent to 16 percent) by any historic standard.
This is not because properties are great bargains, but because mortgage rates are still very low. When the rates begin to move up with the Fed (they usually lag, but ultimately move more), this unusual and favorable buying and selling will no longer exist. (You’ll notice I did not equivocate in predicting the situation will end, but the timing is still in question.) The only way buyers can compensate for higher interest rates is to buy properties for lower prices or out sit the game.
The Actual State of the Market
The self-storage market is immensely flush with money from buyers and their lenders, and buyers are paying the highest prices in the last 40 years for real property income. In addition, buyers have finally recognized self-storage as a legitimate and respected type of real estate.
As evidence, look to the fact established types of real estate have cap rates in line with those of selfstorage. The following chart reflects this parity. Also, the “spreads” lenders charge above Treasury bond rates are generally comparable with the other types of real estate, once again indicating self-storage has “arrived” in the real estate world. The net result is the risk premiums that were calculated in values in past transactions are absent in current pricing.
If you are a buyer, now is a great time to buy, despite higher prices. (See my article, “The End of an Era,” in the January issue for details on why this is so.) The amount of money you save in interest can make up for the price you pay—and a lot more. However, as with any property purchase, you must conduct a thorough investigation. A good market doesn’t fix a bad project.
Owners of existing facilities should also do some forward thinking. It is entirely possible this elegant confluence of two disparate trends leading to exceptional value and liquidity of investments could turn into the “perfect storm.” After all, trends change. For example, if interest rates rise and overbuilding creates substantial vacancies and rate decreases, the impact of increased selling prices could affect the equity and value of an existing property. Owners would be surprised to learn how sensitive the values are to even modest vacancies, rate reductions and increases in cap rates.
Let’s take a look at a sample market. The local population is 211,200. The market has six existing self-storage facilities at 40,000 square feet each, for a total of 240,000. Average occupancy is 88 percent. A developer comes in and adds a 60,000-square-foot facility. Since demand for the product has not changed, average occupancy now drops to 70 percent. The population has to increase 25 percent just to return to the previous self-storage demand. But even the fastest growing Metropolitan Statistical Area in the United States only grows at a rate of 3.9 percent per year. Average population growth is 1.3 percent annually.
Now take a look at the accompanying charts. “Sample Facility” shows the operating numbers from one of the original six facilities in our example. The last chart shows what can happen as a less competitive facility reacts to the overbuilding.
Will the perfect storm come to fruition and, if so, when? No one knows for sure, but the trends are not positive. Add the fact that submarkets may not reflect the national market because of localized overbuilding, and it becomes clear the answer can vary widely.
Where to Go From Here
In light of all this information, how do you proceed? First, examine your own objectives. If you are young, hope to grow a successful self-storage business, plan to stay around a long time and are willing to compete, then get one of the great mortgages available today. This will not only save you money, it will help lower your cost of operation in difficult times. However, if you are thinking about retiring or find your partners difficult to live with, or are engaged in estate planning, you may want to think about selling. Capital gains tax rates are also at 40-year lows.
First review your property and the market. Talk with the city planners and building department and see what plans developers have for your area. Visit your 10 nearest competitors (and proposed competitors) and get their thoughts. Review your results from the last few years, including rental rates and occupancies. Look at economic occupancy, not just physical occupancy. Make a chart of how your property compares to those of immediate competitors. Look at visibility, location, traffic count, amenities and rates. If you honestly complete this investigation, you will know how you will fare in a storm, even a perfect one.
The question you must answer is if the risk and effort are worthwhile. How long will the window of opportunity last in the self-storage and real estate markets? Long enough, I hope, for your objectives to be met.
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 1994, he created the Argus Self Storage Real Estate Network, now the nation’s largest network of independent commercial real estate brokers dedicated to buying and selling self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.