Whether youre a current self-storage owner or just thinking about entering the industry, the logical question today is whether you should buy an existing facility or build a new one. Although there are many dynamics involved, economics makes the answer simple: buy instead of build.

Overbuilt Markets

From the inception of self-storage, development and growth was steady until 2008. With more than 50,000 facilities nationwide and long-term economic expansion from the early 80s, housing growth was high, discretionary spending was strong, and additional storage space was demanded to meet the needs of mobile families and growing businesses. The failing of Lehman Brothers in September 2008 and the ensuing financial crisis changed the landscape in many ways.

Self-storage development peaked in 2006 and has decreased each year since. Less than 200 new facilities were expected to be developed in 2010, and most of those projects were already in the pipeline or too far along in the process to be stopped.

In some markets, the most recently added facility was one too many and has yet to reach its goals. In addition to lagging lease-up schedules, rental rates are 10 percent to 30 percent lower than forecasted and include promotional discounting. This has resulted in owners applying further capital contributions to keep facilities open, or banks throwing in the towel and foreclosing on properties.

In better times, developers built a facility and sold it at a profit without renting a single unit. Today, a lease-up facility is valued entirely on its cash flow, which usually equates to a value less than the bank loan. This doesnt please the lender, obviously, and when competing local banks find out, they restrict their self-storage lending. Add to this dilemma that banks have plenty of non-performing office, warehouse and retail centers. Their hands are full of problem loans, capital requirements and regulatory oversight.

With these self-storage properties worth less than their cost of construction, its easy to see how much more valuable an existing facility can be, particularly if it has a solid stream of valuable cash flow. Like stock investors in a down market who flock to the perceived safety of the bond market, self-storage investors flee development risks in favor of established cash flow.

Buy vs. Build Equals Less Risk

With overall weakness in the real estate market, investors desire higher return on their investments. This lowers values and increases capitalization rates on properties. Class-A properties have held their values better than B- and C-class facilities. Class-A facilities topped out in the 6.5 percent to 7 percent cap-rate area and are now trading between 8 percent and 8.5 percent, which is not bad, all things considered.

Class-B and -C facilities are all over the map. While they trade anywhere between 9 percent and 11 percent, they tend to bring a wider range of offers, with fewer qualified. They often come with first-time buyers who have the additional hurdle of trying to convince lenders to put their faith in them.

All four of the publicly traded real estate investment trusts (REITs)Public Storage Inc., Extra Space Storage Inc., Sovran Self Storage Inc. and U-Store-It Trustclosed their development divisions in recent years. While this has occurred during economic slowdowns in the past, these shutdowns could last longer. Banks have too many problem loans today and too many coming down the road. Most experts believe development will be meager for at least three years, if not longer, and the REITs are well aware of the price differences and reduced risks associated with buying existing properties.

For a couple of years now, REITs quickly dropped street rents in favor of higher occupancy levels until rents stabilized. They are now at or near the point where any small recovery in the economy could bring the rent increases they favor. The forecast is for small rent increases, but it will be some time before rents are back at peak levels.

Financing Challenges

Financing is scant for new development and tough for established self-storage veterans, while first-time developers have little chance of obtaining a construction loan. This doesnt mean some markets are undersupplied or well-thought-out development projects are without merit. Steel prices are near all-time lows, and subcontractors across the board are looking for work and priced at bargain levels. Many vendors are doing work to break even so they can avoid layoffs and rehiring once business improves. Land cost is also inexpensive. Add in the time required to get a site fully approved for development and you might get lucky enough to open a new facility about the time economic prospects are improving.

When you add it up, total development cost may not be as cheap as buying a new facility, but overall costs are probably 20 percent below what they were a few years ago. Be fully prepared when seeking financing, and have an ironclad business plan, feasibility study and strong financial partners if you want to build today.

What It Means for Buyers

Buyers are in a wonderful position if they have cash on hand. At the onset of the recession, most decided to wait for prices to stop falling. This was the case for most of 2009 and the first half of 2010. As a result, they found few opportunities and sellers who were leery of bottom-fishers.

We also saw distressed properties where the banks first move was to offer interest-only payments to give owners more time to increase occupancy. This meant fewer deals on the market, fewer offers and a dramatic decrease in transaction volume. Volume improved in the latter part of 2010, and owners saw a greater number of offers and some stabilization in pricing.

Buyers are more active. Prices have stabilized. Many buyers are getting anxious to put money to work in an attractive market. Banks today are requiring 30 percent to 40 percent equity in acquisitions, so if you can find a good facility with the conservative financing that comes with it, you can have a solid investment for years to come.

John H. Gilliland is president of Investment Real Estate LLC, which provides full-service self-storage brokerage, management, construction and feasibility services for facilities in the mid-Atlantic and northeastern United States. He can be reached at 717.779.0804; e-mail [email protected] ; visit www.irellc.com .