Is the self-storage industry headed toward another big development cycle similar to the one in the late 1990s?
The high prices investors have been paying for self-storage in many markets represent a significant premium over replacement costs. In market conditions like this, investors shift their thinking from acquisitions toward development.
The median physical occupancy nationwide in the first quarter of 2006 was 90 percent, where it has hovered for a couple of years, according to Self Storage Data Services Inc. (SSDS). Numbers also indicate the self-storage operating performance is strong and growing stronger. Asking rental rates in the first quarter increased 9.4 percent over the same quarter last year, and the number of facilities offering concession decreased appreciably.
Self-storage REITs provided the highest return of any property type last year and reported the second-highest total return (13.03 percent) so far in 2006, according to the National Association of Real Estate Investment Trust.
The number of construction starts reported by F. W. Dodge has been fairly consistent over the past three years, averaging about 300 annually. Some in the industry are concerned the real number is greater—and they may be right. But even if it were double, the new supply represents less than a 2 percent addition to existing inventory. Based upon the historical reliability of the F. W. Dodge data, it seems safe to assume the majority of new supply is reflected.
Characteristics of New Supply
In the first five months of this year, construction began on 116 projects. Ninety-four of these were new facilities with a median size of 38,400 gross square feet, adding approximately 3.6 million gross square feet to the existing inventory.
The remaining 22 projects involved alternations, renovations or additions—bringing a second infusion of 1 million square feet of supply. Thus, we can estimate the industry will add about 11 million gross square feet this year.
Median direct-construction costs ran about $49.60 per gross square foot (excluding soft-cost and land value). New starts in the first quarter were evenly distributed around the country.
In the same period, F. W. Dodge tracked 666 projects in the self-storage pipeline, as shown below. The number of actual starts (116) represented less than 20 percent of the whole.
Projects in the planning phase numbered 263 at the end of March, a 33 percent jump over the quarter ending 2005. By the end of May, the figure increased by 50 percent. Part of the upsurge could be seasonal.
If all 666 projects in the pipeline were to be constructed, the supply of self-storage would swell by 40 million gross feet, with direct construction costs exceeding $2 billion.
Self-Storage Construction Pipeline
Number of Facilities, January-May 2006
Final Planning - 36
Planning - 341
Pre-Planning - 13
Start/Final Planning - 4
Subtotal - 394
START PHASE - 116
Bidding - 11
Bid Results - 14
Deferred - 34
Occupancy - 8
Permit - 31
Sub-Award/Construction - 2
Subtotal - 156
Grand Total - 666
Profit margins on new development can be high, but only if the developer properly assesses risk and researches the market to determine feasibility. Now that pent-up demand has been satisfied, developers can no longer rely upon the proven unit mix of yesterday’s marketplace. Nor can they depend upon general measures of supply such as square feet per capita to guide them in determining market equilibrium.
As the graph above illustrates, new supply in the last couple of years has been limited. The focus of REITs and other major market participants has been directed toward acquisitions, not development.
In many instances where oversupply becomes a problem, it’s usually site specific and design related; i.e., the wrong unit mix for the specific location. This is the result of developers not recognizing they must study marginal demand and consider their market penetration.
Self-storage won’t become overbuilt overnight in all markets. Overbuilding will be a long slow process, happening one-size unit at a time. Some new facilities fill slower than anticipated because of poor unit mix: Developers fail to measure the marginal demand for a certain-sized unit, and are unaware of the oversupply.
Marginal demand refers to what remains after available space is subtracted from the projected demand. Today, the self-storage marketplace requires more sophisticated methodology of measuring demand than what is used by analysts in other property types.
Big Development Unlikely
Several factors indicate there won’t be another big development cycle anytime soon.
- Interest rates are increasing and for the majority of developers that could mean that proposed projects are no longer financially feasible.
- Material costs and possible labor shortages are more of a concern.
- The entitlement process is taking longer; cities are more concerned about overbuilding, and prefer projects that provide higher employment and sales-tax revenue.
Charles Ray Wilson, MAI, CRE, is the founder of Charles R. Wilson & Associates, Inc., a full-service appraisal firm, and the founder of Self Storage Data Services