How well did self-storage perform in 2006 compared to other types of real estate? If you’re an owner, you know how well you did last year, but how did you compare to everyone else? Here is a look at the status of self-storage and its changes over the past year—changes that may influence your management and investment decisions.
A softening housing market and concerns over the economy failed to slow tenant demand for space last year. Self-storage REITs outperformed the S&P 500 and the Morgan Stanley REIT Index in terms of total returns in 2005. The four self-storage REITs along with the rest of the self-storage industry continued to attract national attention in 2006 by posting solid operating performances. At the same time, operating fundamentals continued to strengthen.
Changing Investment Market
The biggest change in the investment market in the past 12 months has to do with who’s buying. Today’s buyers can be characterized as regional and local investors, many of whom are new to the industry. They’ve replaced the REITs and many large operators who’ve either slowed their pace of acquisitions or stopped altogether. The reason larger investors stopped buying is partially due to the lack of available Class A facilities in major markets, their preferred property type.
Some stopped acquiring because of the irrational and sometime frenzied investment climate of the past couple years. However, a number of investors believe the run up in prices has now reached the point that new development may be justified, even in markets with high barriers to entry.
Public Storage, the largest REIT, and Extra Space, one of the newer REITs, are busy digesting huge portfolio acquisitions and aren’t actively seeking additional facilities. However, one or two operators are still hopeful of going public and are willing to pay top dollar to bulk up their portfolios.
The shift in investors from the traditional REIT or large operator to the new regional or local investor, and the lack of product has caused a slowdown in the pace of Class A transactions.
On the other hand, many Class B and C facility owners who waited to enter the market are now offering facilities for sale, resulting in increasing inventory. With so many investors in this category who are new to the industry, transaction times (the time from listing to closing an actual sale) have reportedly increased as due diligence and closing requirements intensified.
Some owners are going directly to investors rather than using brokers, potentially a big mistake considering many new investors don’t understand the nuances of self-storage. While investor inexperience could translate to higher prices, the increased availability of Class B and C facilities is more likely to translate to higher cap rates and lower prices.
Today’s investors, lenders, appraisers and anyone else involved in the analysis of self-storage are finding it increasingly important to differentiate between the quality of facilities and their locations when measuring risk. Failure to recognize the risk characteristics between Class A, B and C facilities has resulted in some investors paying Class A prices for facilities that are substandard in quality or locale.
Few Class A facilities are available for purchase, and scarcity creates value. Capitalization rates are not expected to increase any time soon. Based upon the small number that have sold, facilities are going for cap rates ranging between 7 percent to 7.25 percent, using stabilized forward-looking net operating incomes. The majority of Class A facilities on the market are still in fill-up and priced upon the seller’s pro forma numbers, which aren’t necessarily reflective of current market conditions.
Due to the rising cost of acquisition capital, and the increased number of Class B and C facilities offered for sale, cap rates in these asset class are moving upward into the 8 percent to 9 percent or higher range.
Cap rates on facilities of all classifications are being impacted by those stores developed over the past three years. Some developers were caught off guard by the dramatic rise in construction costs, longer-than-expected construction periods and—in a growing number of neighborhoods—slow absorption. The facilities aren’t achieving their anticipated financial objectives and developers are looking to make their partners whole by shortening the investment-holding period. The pricing, and therefore the cap rates, will reflect the pre-stabilized nature of these situations.
The cost of new development, particularly in the major markets, has helped keep the pace of new construction to a minimum. Based on data from F. W. Dodge and other sources, the number of new starts has been stable and isn’t a threat to the industry generally. A few submarkets have experienced a heavy concentration of new construction, resulting in facilities slow to stabilize. Some properties have had difficulty achieving economic occupancies of 70 percent and in a few cases 60 percent.
The following performance statistics are based upon a sample of 6,000 to 7,000 facilities that Self Storage Data Services Inc. (SSDS) tracks every 90 days. It represents one-third of all facilities in the nation’s 50 largest markets. As the Self Storage Performance Index (SSPI) illustrates, self-storage has not been negatively impacted by the downturn in the housing market or by the concerns over the economy during 2006.
During the most recent two-year period ending second quarter 2006, the median-asking-rental rates nationwide increased approximately 6.5 percent annually, going from 80 cents to 91 cents per square foot.
Interestingly, the rates peaked at 93 cents in first quarter 2006. The markets demonstrated a wide variation in operating performance as demonstrated by asking rental rates. While the South stayed true to its history, achieving the strongest performance, it was Texas rather than Florida that led the way in third quarter 2006. The Midwest saw a nearly 4 percent decline in asking rents due to soft market conditions in major markets like St. Louis and Kansas City, Mo., and Milwaukee, Wis.
Median physical occupancy nationwide usually doesn’t vary significantly without a major change in the supply. But during second quarter 2006, it jumped from 90 percent to 92 percent before falling slightly later in the year.
The Midwest remained level at 90 percent while the balance of the country generally saw 1 percent to 2 percent in third quarter 2006.
On the other hand, Texas experienced a 5 percent gain in physical occupancy, increasing from 85 percent to 90 percent based on a sample of 11 percent of all facilities in that market. Florida’s occupancy remained level at 93 percent.
The shrinking number of facilities offering concessions is further evidence the markets remain strong despite the softening housing market and an uncertain economy. Concessions have decreased six out of the last seven quarters. As of third quarter 2006, 27 percent fewer facilities offered concessions than in the last quarter of 2004.
Nationwide, rent per occupied square foot increased 8.5 percent during third quarter 2006 compared to the same period the previous year. However, in the Midwest it was a different story. With asking rents having declined nearly 4 percent (and more than 11 percent in some areas), and physical occupancy remaining flat at 90 percent, rental income declined 2 percent after considering the impact of concessions.
The declining trend in rent per occupied square foot is regional in scope and started in the beginning of 2006. Self-storage investment yields are every bit as good or better than other types of real estate.
Self-storage operating performance across the country is healthier than it was 12 months ago. Thus far, the weakening housing market hasn’t adversely impacted demand. Barring a major economic downturn, owners who operate professionally should see strong performances in the months ahead. The demand for space today exceeds the pace of new supply in most markets.
In 2006, there were fewer Class A transactions, due to limited availability and a wider spread between bid and ask. The volume of Class B and C transactions is reportedly comparable to last year as more owners plan their exit strategy.
While soaring development costs have held the lid on construction in the past, given the recent premiums paid for Class A facilities and continued tenant demand, new development may now be justified even in markets with high barriers to entry. Operationally, self-storage is poised to benefit from the disruption caused by the slowing housing market and the changing economy.
Note: The Self Storage Performance Index (SSPI) and other products referenced herein are either copyrighted or trademarks of Self Storage Data Services Inc. (SSDS) and are reprinted herein with SSDS’s permission.
Charles Ray Wilson is the founder of Charles R. Wilson & Associates, Inc., a full-service appraisal firm that specializes in the valuation of self-storage facilities nationwide, and the founder of Self Storage Data Services Inc., a leading manager and publisher of economic and operating statistics relating to the self-storage industry. For more information, visit www.ssdata.net or www.crw.com .