By Tony Jones
Despite the hardships suffered by many self-storage owners during the last three years, the flexibility afforded to storage facilities has helped the industry adjust to market fluctuations and avoid the devastating declines experienced by other commercial real estate segments. Low capital expenditures on existing facilities, short-term contracts and frequent rental-price adjustments have enabled many owners to ride the ebb and flow of supply and demand to protect property performance and value.
We have seen rentals start to increase or at least flatten out, and most of the discounting is being slowly squeezed out of the market, notes Ben Vestal, president of Argus Self Storage Sales Network Inc. This is bringing more stability to the investment class and, more importantly, the financing of self-storage investments. As a result, the self-storage real estate segment has teetered but not fallen and emerged from 2009 transaction lows squarely as a buyers market.
A greater number of buyers have emerged for existing facilities, and they have been more particular on the property types they look to own, explains John Barry, vice president of brokerage for Investment Real Estate LLC. They are seeking quality properties in excellent locations and will pay a fair price for these, or they are looking for extremely reduced prices on lesser class facilities.
The crux, of course, is financing remains a challenge for many would-be buyers, and changes in valuation underwriting have made brokering deals more difficult for sellers. Demand and rates appear to be bouncing along the bottom, not knowing whether we are improving, or just holding the line on performance, says Vestal. There are several buyers in the market for well-run, stable investments. The valuations today are subject to new underwriting criteria that are here to stay. The new reality is that the commercial real estate market has more to do with the value of your self-storage facility than the performance of the actual facility.
By most accounts, transaction volume in 2010 surpassed 2009 activity, but that upward movement was tempered somewhat with more properties being moved into foreclosure and lenders accepting short sales, notes Barry. Nevertheless, because more opportunities have developed in the market, more buyers have appeared, and the offers have tightened up quite a bit, he says. I would expect to see that trend continue this year.
Market conditions overwhelmingly favor well-capitalized, experienced buyers and have put a crimp into transactions under $3 million. Large, high-value properties are achieving cap rates 100 to 300 basis points lower than smaller, less valuable properties, Vestal says, creating a gap that makes it impractical for cash-rich buyers to broker smaller deals.
Well-capitalized buyers in the market today are unable to obtain smaller loans at a competitive rate that is necessary to make the smaller deals work, explains Vestal. Additionally, they are unable to achieve the economies of scale necessary to make their new financial model work.
That leaves smaller operators dealing with buyers who either do not have sufficient capital or cannot get favorable interest rates and terms from lenders uneager to jump into smaller transactions.
It is still very difficult to transact a deal today due to the lack of high-leverage financing tools and, more importantly, the lack of liquidity of small real estate investors, notes Vestal.
Conversely, 2010 was marked by several large transactions and portfolio sales. In some markets, like California, transactions were essentially frozen except for portfolios or distressed properties, according to Stephen Grossman, senior vice president, Self Storage Investment Group. Portfolio sales have been occurring more frequently than ever, he says. The motivating factor for these sales has primarily been the need for new financing.
Single property owners typically have not put their storage facilities up for sale, Grossman says, unless they have compelling reasons to do so. Other than retirement, relocation or an offer too good to reject, single storage owners across the nation simply have had few positive reasons to seek a sale. Many properties are upside down, and owners have little leverage to refinance their loans.
With values down 20 percent to 40 percent in some areas across the country, self-storage owners who are not pressed to sell are holding on and will wait for better times, which may be two to three years in some markets and up to five in others, notes Bill Alter, self-storage specialist, Rein & Grossoehme Commercial Real Estate. Even mature properties with loans coming due are facing problems. Lenders seem reluctant to take many of these properties back and are working to some degree with owners.
Alter is among those who believe transaction volume will continue to increase in 2011, as many mature and distressed properties are expected to find their way to market. Lenders, he says, are poised to move away from the extend and pretend mindset in which banks work with borrowers to extend loans to give owners time for their markets to recover.
Transaction volume has increased significantly in 2010 vs. 2009, and we have yet to really see the distressed or toxic assets come to market from the lenders/special servicers, agrees Nicholas Malagisi, national director of self-storage for Sperry Van Ness/Commercial Realty. They are coming, but slowly.
Owners who have loans coming due from placement five to seven years ago are going to be hard pressed to refinance without bringing new equity to meet the more strict underwriting standards of lenders today in regards to valuation, he continues. There are many other similar situations going to be coming due within the next 18 to 24 months across the country where selling will take precedence over refinancing.
Grossman also agrees distressed properties will move more quickly in 2011. The lenders and note holders have waited almost 18 months to decide how to handle the nonperforming assets, he says. Generally speaking, theyve started foreclosure proceedings at a more fluid pace, and in turn, receivers are being inserted into the management of the asset. Once the properties are stabilized by the receiver and internal controls are in place, the property is put on the market at a discount.
Despite the volatility of the market, cap rates have held fairly steady, generally running in the range of 7.5 percent to 9 percent for class-A facilities, while class-B and -C facilities have ranged from 8.75 percent to 11 percent, depending on the situation and existing cash flow, according to Barry.
For a quality, stabilized property, the cap rate now is probably 7.5 percent, says Alter. Older, first- or second-generation properties will trade for 50 to 100 basis points higher.
Interestingly, in California, public real estate investment trusts (REITs) have exerted upward pressure on cap rates while nontraded, private REITs have done the opposite, says Grossman.
Determining value has become more problematic behind the influx of distressed properties. Appraisers and buyers are relying on the income capitalization method for valuation, rather than using comparable sales.
Valuation utilizing comparable sales data is dangerous right now, stresses Malagisi. Because there have been so many sales of distressed assets still occurring, it would tend to lower the overall price-per-square-foot comparison to the detriment of stabilized facilities.
It is still unclear how to determine the value of properties built in 2006-07 that are less than 50 percent occupied, notes Alter. In many cases, those properties have little or no net operating income. In those situations cap rates and current income are meaningless. However, buyers like to say, If its three years old, its stabilized.
Despite the availability of land, new construction projects have declined four consecutive years in the self-storage industry. The outlook for development in 2011 remains bleak, largely due to a lack of available financing and the number of distressed and mature properties expected to come up for sale in oversaturated markets.
The main problem with new construction is the lack of or nonexistence of construction funding, says Grossman. Until the current supply of distressed storage properties is resolved, new construction will not be in the pipeline.
There are plenty of entitled sites on the market, but nobody wants to build in this environment, agrees Alter. Anyone venturing into new development should be thinking all cash and had better do their homework.
Of course, a lack of new builds lends itself to an increase in conversion projects, which can breathe new life into underperforming properties and be attractive solutions for landlords looking for tenants that can generate income.
I believe we will see many of the established operators considering conversions in markets where their properties are performing well. This will be driven mostly by the lack of construction financing and not necessarily because they like conversions, notes Vestal. In urban areas, where the barriers to entry are high due to a lack of available ground or entitlements, we will continue to see conversions play a major role in new storage projects coming online.
Whether or not these projects occur quickly, however, is another matter. [Conversions] will be more common, although it may be longer than a couple of years, explains Barry. With a lot of vacant space in retail properties, more landlords are considering all options, including self-storage. We have seen more inquiries into shopping center locations, especially where these properties need to derive some type of income.
These locations do not offer the same type of main road drive-by traffic, but they do offer community traffic that frequents the local retail outlets, he continues. More property owners will likely consider any other type of vacant building, as well, but unless they are well-funded and cash deals, getting lenders to approve more self-storage development could be tricky for a few years.