This month, I gathered real estate experts to discuss the state of self-storage in the West. Let’s hear what they have to say about their respective cities and regions. Our panel includes: Richard Arnold, Arnold/Forcum & Associates, Portland, Ore.; Roxana Baker, Grubb & Ellis, San Jose, Calif.; Clifford Crowe, Lee & Associates Inc., Carlsbad, Calif.; Larry Hayes, Hayes & Associates, Missoula, Mont.; Larry Kudla, American Realty & Investment, Las Vegas; Joan Lucas, Joan Lucas Real Estate Services, Denver; Michael McVay, Lee & Associates Inc., Carlsbad, Calif.; and Jim Ramsay, Coldwell Banker Commercial, Redding, Calif. My comments are in italics.
In your market, have you seen cap rates fall in the last three months? Are they higher than they were at the end of 2004?
Arnold:I’ve seen cap rates fall in the past 12 months, but not the past three. I believe cap rates have fallen about 1 percent in the past year.
Baker:Cap rates in Silicon Valley and the San Francisco Bay area have been very low for the last year or so, in the 6 percent to 7 percent range. There’s a lot of money chasing a limited number of viable properties in addition to low interest rates and lack of investment alternatives. Cap rates are still going down into the 5 percent range.
Crowe:In Southern California, cap rates seem to be lower in the last several months than they were earlier in the year.
Kudla:I have seen cap rates get lower in the Las Vegas market.
Lucas:Due to a shortage of supply in my area, demand continues to affect cap rates. In reviewing a list of closed transactions from the last several years, I’ve seen a steady decline in cap rates from a high of 11 percent to a low of 7.5 percent.
McVay:The cap rates on properties sold by brokers have not changed over the past year. If anything, they’re lower.
Ramsay:I’ve seen cap rates in California dropping to a new low over the past 12 months. They seem to have stabilized over the past 90 days, with investors realizing how low you can go and still make a reasonable, safe investment. Rates are definitely lower now than they were at the end of 2004.
How low is low? With interest rates rising for the 11th time, cap rates will eventually increase. A 2 percent rise in cap rates will drop the price of a facility by 20 percent and the average equity by about 50 percent. It looks like the risk is greater if cap rates go up than the gain if they go down. (See my recent article “Interest Rates, Cap Rates and Betting the Farm” in the November 2005 issue.)
Are self-storage transactions harder to close? If so, why?
Arnold: I don’t find transactions harder to close, except in cases where the seller is attempting to make a tax-deferred exchange. It’s becoming more difficult to find a suitable exchange property.
Baker:Lenders on all types of investment properties seem to have more stringent parameters and require larger down payments, slowing down the buyer’s mortgage processing and final close of escrow.
Crowe:With a tighter market, buyers and sellers are more concerned about the details.
Kudla:I don’t think transactions are harder to close—just the opposite, since lenders and investors have a better acceptance of the product.
Lucas:Whenever conduit lenders are involved in a transaction, much more documentation is required during due diligence. For sophisticated sellers and buyers, this is no problem. On the “mom and pop” transactions, we’re typically dealing with local lenders who understand the property and type, and the closings are relatively painless.
Ramsay:All transactions are harder to close. As investments are more difficult to find, sellers and buyers become more demanding. The risk factors are approaching the same costs as fed and state capital-gains taxes, leaving all parties feeling pressed. Sellers seek to find another 1031 Exchange property that is equally as good (and most can’t). Buyers demand to know their investment dollars are buying “near perfect condition” properties while paying 4 percent to 6 percent cap rates. Sellers are not willing to fix anything that would generally be repaired or replaced under normal market conditions.
McVay:Transactions are not getting harder to close. Lenders still desire the self-storage sector, and the loan-to-values are still being quoted around 80 percent.
The first indication that a good market is going soft is the deals are more difficult to close. Buyers are a little less convinced and, thus, tougher to deal with on smaller issues. When it becomes a pattern, it’s a sure thing the market will change.
Are you seeing more buyers or sellers in your market? Have you seen an increase in both over the last year? If so, what do you think has caused the influx?
Arnold:I’m finding lots of buyers and very few sellers. I think the market is at its peak, and though buyers are plentiful, owners are not interested in becoming sellers. This is likely due to the fact they don’t want the tax bite and have trouble finding other real estate that will give them a similar return.
Baker:There are lots of buyers and “tire kickers.” Not many have switched to self-storage from office, R&D or retail properties just yet. Most get turned off by the high prices relative to achievable cash flow no matter what the product type. It looks like the large self-storage chains are selling portfolios, but not many “moms and pops” are selling.
Crowe:I haven’t seen much of an increase in sellers, but we continue to have a ton of buyers. A lot of them purchasing at lower cap rates are those coming out of 1031 Exchanges.
Hayes:There are still a lot of buyers and little inventory in my market. I don’t think there are more buyers than in the past, just frustrated ones who have not found something to meet their criteria.
Lucas:The situation has not changed in the past decade. There are probably 100 buyers for every good self-storage facility. The reason is everyone hears about the great returns an investor can achieve, pure and simple. Are there more sellers? Definitely. But several years ago, there were many developers looking for sites on which to build. That is the piece of the industry that has diminished, due to overbuilding in so many sectors of the state.
McVay:There are definitely more buyers in Southern California, but we’re also starting to see more owners thinking about selling.
Ramsay:There are a lot more buyers looking for investments. It seems to be somewhat of a seller’s market in California, but sellers can’t seem to replace their properties for the same return on investment. The market is settling down, and buyers/investors are realizing they can’t pay current prices with any degree of safety. In areas of heavy residential growth, self-storage can still expand to some extent; however, in stable areas or those with little or no growth, the market may soon be overbuilt. Investors are always looking for alternatives and opportunities. Cash flow with safety seems to be the norm.
It appears we are approaching some balance between buyers and sellers. Will we overshoot it? Who knows, but it usually works that way.
Do you have any stories to share about overbuilding in your market? Is it becoming a problem?
Arnold:While discussing overbuilding with one seller, I was told that although his vacancies had slightly increased, he had raised rents to be in-line with those needed by new-facility developers to accommodate higher construction costs. Vacancy increased, but rents improved enough to offset it.
Baker:Silicon Valley doesn’t have much available land zoned for self-storage. Buyers looking to develop have few infill sites from which to choose, and labor and construction costs are quite high. Therefore, overbuilding hasn’t been a problem in most cities in my market.
Crowe:I think each pocket within a major market needs to be evaluated individually.
Kudla:There is no overbuilding is my market. This is a growing area. I would venture to say it’s is not an issue in other Nevada markets either.
Lucas:Several years ago, an experienced developer got approvals to build a 100,000-square-foot facility in a thriving part of town. The plan was staged development. Unfortunately, due to problems with the city, he was forced to complete the entire project at once. A year and a half later, a second developer came into the market with a similar facility on a less favorable site just two miles away. Does anyone want to guess how long it took the facilities to reach breakeven?
McVay:There really isn’t an excess of overbuilding in my area because of zoning restrictions. There are a couple of markets in the Los Angeles area that may be overbuilt, which causes facilities to offer numerous discounts, but they aren’t suffering.
Unfortunately, California and Las Vegas are the exceptions in comparison to the rest of the country. I’m hearing more stories like the one Lucas related. It’s time to do a check up on your facility and market.
As you look back at 2005, what are your thoughts on the self storage market in general? What would you like to see in the coming year?
Arnold:I think self-storage is the best investment available in the real estate market. In the upcoming year, I’d like to see more owners become sellers, but I really don’t expect that to occur—just yet.
Baker:Lots of additional housing units are being built, replacing some obsolete industrial areas, and there aren’t a lot of new self-storage facilities under construction. This should portend well for existing facilities, which are running at about 90 percent occupancy in the greater San Jose area. Also, quite a number of new retail centers and mixed-use developments are going up. It’s probably a good time to build a limited number of self-storage facilities or expand existing ones in or near the changeover areas, providing the cities will allow the use.
Crowe:The storage market continues to be a good one. I see more lenders and investors recognizing self-storage as a good property type compared to others.
Lucas:This is a thriving niche of commercial real estate. There are many sophisticated buyers looking for quality properties. If a facility is priced right, everyone is assured of a successful closing within the shortest amount of time. Our markets are going to be overbuilt for quite some time. I hear from new people in the industry who want to build, build, build. They tell me there are 15,000 new homes going into a given area. What they haven’t taken into account is the time it will take for a community to be fully built out. Couple that with the fact that only 10 percent to 12 percent of the population uses self-storage. We continue to create our own problems.
McVay:I think a lot of owners who were thinking about selling but didn’t will regret it. It looks like there will be much more product available next year, and it will cause values to slightly decrease.
Ramsay:As investment opportunities become more competitive, self-storage is more acceptable to lenders at competitive rates. Since the stock market crash in 2000, investors have been looking at more reasonable and steady income streams. Self-storage fulfills these requirements. In my market, I’d like to see sales prices related to cap rates become more realistic—7.5 to 10—and have more sellers selling established sites. Also, where there is economic demand, I’d like to see more property zoned for self-storage and more facilities constructed.
McVay made a very important point. If you’re thinking about selling in the near to intermediate term, now is the time. Waiting is risky business with limited potential rewards. If you plan to hold for five years or longer, it’s still a great opportunity. Just keep an eye on new competitors.
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; visit www.selfstorage.com.