Inside Self-Storage 2/98

By Aaron A. Swerdlin and H. Dan Miller

The last three to four years have been very exciting for the self-storage industry. Since June of 1994, more than $1.5 billion in self-storage properties have changed hands--a volume the industry has never before seen. Will this level of activity continue? More importantly, what can the industry do to insure that this high level of activity continues?

Obviously, the REITs (real estate investment trusts) are the key ingredients to maintaining a $5 million per-year consolidation volume (they have been involved in more than 75 percent of the ownership changes in the last three years). Therefore, in order to understand what will keep this volume going, we must understand the REITs and their motivations.

REITs are companies whose sole business is buying, developing and operating real estate. REITs have been in existence for many years. Most REITs are publicly traded on one of the stock exchanges, which means that the ownership of the company is distributed among several million shares and several thousand shareholders. Between 92 percent and 95 percent of the profit that the company generates is passed to the shareholders through dividends. The REIT itself does not pay income tax on its profit, because along with the income, the tax burden is also passed to its shareholders (the shareholders simply pay income tax on the dividend income). The per-share price of a REIT stock is usually directly related to its dividend, which makes REIT stocks much like bonds and utility stocks. In today's financial climate, REIT investors look for a REIT stock to yield between 5.5 percent and 7.5 percent, depending on the overall strength of the company. About 250 REITs are publicly traded on one of the stock exchanges. Of the 250 or so REITs, five focus solely on self-storage properties.

There are several reasons why the publicly traded storage REITs (Public Storage, Storage USA, Sovran Self Storage, Storage Trust and Shurgard Self Storage) are acquiring as many properties as they can. As Wall Street is investing money in the self-storage REITs, the REITs will continue buying. Wall Street will continue investing in the self-storage REITs as long as two elements exist: strong financial performance from the self-storage REITs and a bullish stock market. If either of these two elements cease to exist, the optimism that has fueled the buying frenzy will become more cautious and probably slow down.

How do the REITs continue to post strong, quarterly performance? It's quite simple: Grow FFO (funds from operation), grow occupancy, grow revenue and grow the asset base (acquisitions). So far, the REITs have consistently posted strong growth numbers. For example, Storage USA has more than quadrupled in size since its IPO (initial public offering) and Storage Trust was one of Money Magazine's top ten performing REITs of 1996.

The main reason REITs have performed so well is supply/demand ratios have favored owners, a trend that is beginning to change. Real-estate investors are constantly searching for a competitive advantage. Many local and national apartment, office and retail investors are acting on the self-storage REITs' success and diversifying their portfolios by developing new self-storage projects. The problem is, many of these developers have adopted the motto, "Build It and They Will Come." Obviously it is not that simple.

The key to a successful site depends, in large part, on supply/demand ratios. Too many sites that have been built or in the planning stages, are going to simply distribute the same number of renters among more units, an equation that leads only to occupancy and revenue declines. The best way to ruin, or at least slow down the momentum, is to begin to overbuild the marketplace. Long-term, excessive building only benefits the REITs as they will come into overbuilt markets and buy the distressed deals after the banks take them back (like many investors did in the early '90s). Short-term, overbuilding hurts everyone.

Interest rates are the second ingredient to the recent success formula. Sellers have been amenable to selling because cap rates are as aggressive as ever. The only reason cap rates are so low is interest rates are low. If a company borrows money at 7.75 percent and requires a 300 basis-point (3 percent) spread between the cost of debt (the interest rate) and the return on investment, then the target cap rate is going to be 10.75 percent. The companies require a spread between the return and the cost of funds because they have dividends to pay, operating expenses to absorb, etc. If their interest rate goes to 8.5 percent, the cap rate goes to 11.5 percent because the company is still going to require a 300 basis-point spread. The cap rate is simply going to increase accordingly. What does this mean to the owner of a $2 million property? If a property generates $250,000 in NOI at a 10.75 percent cap rate, it would be worth $2,325,581. At an 11.5 percent cap rate, the value would be $2,173,913, a difference of more than $150,000 from just a 1 percent change in interest rates. Imagine what would happen if interest rates increase 3 percent or 4 percent.

In my opinion, the activity level we have seen during the last three years is not going to continue, but I think the level of decline will be market-specific--more in some markets, very little in others. Why? Banks are loaning construction money on deals that shouldn't be built, which results in overbuilding and unfavorable supply/demand ratios. What can we do, as an industry, to continue to build momentum and not stunt it? Cautious optimism. The industry is still very strong, and there are few indicators suggesting any substantial change ahead. There continues to be a tremendous amount of opportunity to capitalize on the success of the industry. The secret: Be strategic. The resale market is very active right now, but it's not going to stay that way forever.

If selling a property is in your future, the self-storage REITs are, and will continue to be, the most logical buyers in most markets, because of their availability of capital and aggressive acquisition strategies. They can afford to pay more for most properties than an individual buyer or private company. One of the secrets to realizing the full value of a property is the manner in which it is marketed to the REITs. A real-estate broker is vital to an effective marketing campaign. Real-estate brokers are not getting paid to know who the buyers are. They are getting paid to manage the sensitive process of marketing the property and implementing a very methodical, property-specific plan.

What does this mean to the average self-storage owner? It all depends on your motivation. If you are going to be a seller anytime during the next five years, now is the time to at least test the waters. Sales prices haven't been higher than they are today, so if nothing else, marketing your property is a free appraisal.

Key indicators that your market is about to begin to "soften" include the following:

• New self-storage properties are being built in areas that already have an adequate number of facilities.
• Occupancy declines.
• Rental rate increases are not achiev-able at least once a year.
• Acquisitions slow down.

The industry is going to continue to evolve and become more sophisticated, which will benefit everyone. During the next couple of years another $1 billion worth of acquisitions will occur. With the various ways to structure cash and tax-deferred sales, it is an appropriate time to consider all options. So, what can the industry do to insure that this high level of activity continues? Don't let the high-activity level drive decisions. Let the decisions drive the activity level.

Aaron A. Swerdlin and H. Dan Miller are spearheading the CB Commercial Self Storage Advisory Team, a team of CB Commercial Real Estate professionals focused solely on the real-estate needs of the self-storage industry. Mr. Swerdlin is the former director of acquisitions for Storage Trust, one of the five self-storage REITs. Together, Mr. Swerdlin and Mr. Miller have been involved in the acquisition and disposition of more than $220 million in self-storage property. They can be reached by calling the Houston office of CB Commercial at (713) 840-6500.