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Self-Storage Real Estate Challenges: Pricing, Debt and the Market

Michael L. McCune Comments

After reviewing the year’s financial reports from the self-storage real estate investment trusts (REITs) and hearing feedback from self-storage owners, I’ve concluded that the industry is doing pretty well in this Draconian economic climate. After the first quarter of 2009, most of the REITs were very close―or, in some cases, even a little ahead of the game―to their revenue and net operating figures from the first quarter of 2008.

A recent survey of self-storage owners revealed that very few are having serious problems with operating revenue where their markets are stable, although delinquencies are up somewhat. On the other hand, few owners were experiencing much growth in revenue or rental rates. Many new properties are leasing up slowly, which probably indicates that new rental demand is generally weak. Existing renters are more willing to stay put, but prospects are less likely to rent.

Despite the industry-wide belief, self-storage is more recession-resistant than recession-proof, but even that’s really good for our team.

The Real Estate Side of Self-Storage

This is the part that’s not good news. The problems we face in self-storage today fall into three general categories: pricing, old debt/new debt, and the market.

Pricing. Real estate pricing depends on the market capitalization rate (cap rate) at which the income of a property is discounted. The lower the cap rate, the higher the price, which, of course, makes the reverse true as well. Cap rates for the entire commercial real estate market were at long-term historic lows (meaning higher prices) from early 2005 to late 2007.

In addition to cap rates declining dramatically, property appraisals were also increased because higher anticipated rents and occupancies were added into the income, which was capitalized into the value of the property. The traditional cap-rate model for valuation was (and is again) that net operating income (NOI) was based on the trailing 12 months of actual income. Thus, prices were inflated by the lower cap rates and the positive assumption of future rents.

Just to give you a little perspective, in 2006, it would not have been unusual to see a property with a $200,000 NOI and a 10 percent anticipated increase in rent to be valued on a 7 percent cap rate and, therefore, valued at $3.19 million. Today, the cap rate would be in the range of 8.5 to 11.5 percent (more on this later). Just to use a number, let’s assume the cap rate is 9.5 percent and the NOI is actually down 7 percent; the value of the same property is now $1.9 million, a loss of 40 percent.

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