The major institutions that provide market analysis on the commercial real estate (CRE) industry predicted earlier this year that CRE values would decline anywhere from 10 to 20 percent. They correctly predicted certain property types would feel the credit crisis more than others, but what do these types of market prognostications mean for self-storage values?
Combined with daily negative media coverage about broader Wall Street market conditions, these types of analytical reports can be enough to worry any investor. However, a closer look at the net effect of property value declines may ease some concerns.
First, the media’s tendency is to exaggerate issues such as CRE values. If you look closely at numbers used in media reports, you’ll see they are typically based upon a market’s peaks and troughs, which create wider perceptual swings for readers. But, everything is relative, so when hearing reports of widespread margins, keep in mind what those margins are relative to.
Two recent storage industry examples can help put this into perspective: the revival of the Detroit storage market and the downturn in South Florida.
Ups and Downs
For the past few years, the Michigan economy has experienced recessionary periods with loss of jobs, income and population. Storage performance in the Detroit area was at an all-time low and viewed as one of the worst performing markets in our industry. Recently, Detroit has been cited as one of the better performing markets for REITs in 2008.
As a second example, hurricanes ravaged communities in South Florida in 2005 and created instant demand for self-storage. Once area homes were rebuilt or renovated, storage tenants exited the market, which immediately decreased occupancy levels. With renters gone, the South Florida storage market became a hindrance for REIT performance.
In both of these examples, the reports were based on the peak and trough of each market. In Detroit’s case, the downturn was so significant that a bottom was reached. Now that the market is experiencing positive gains, the growth numbers become magnified and reflect a healthy market. In South Florida, occupancy levels hit all-time highs across the board immediately following the storms. But once the market returned to normalcy, the year-over-year decline was viewed negatively even though the market was back to pre-hurricane levels.
The same theory can be applied to the CRE industry and the decline in self-storage values. The period from 2005 through the first six months of 2007 could arguably be termed as the CRE (including self-storage) relative to transaction activity and pricing. Using storage commercial mortgage-backed security activity as a benchmark, more than $6 billion was placed in self-storage during this period compared to just $2.5 billion from 2000-2004.
Transaction activity from 2005 to mid-2007 was at an all-time high with the capital markets being the main driver. The availability of capital combined with historically low interest rates and creative debt options allowed investors to purchase properties at a feverish pace, which benefited sellers and created an artificially inflated market.
During this peak period, investors could secure financing that required little equity—in some cases as little as 10 to 20 percent—which enabled them to capitalize on an aggressive lending market. For the first time, the low amount of required equity allowed private investors to participate in an arena with the larger institutional players on a fairly level playing field.
Today's CRE Values
During the peak, class-A properties would trade in the plus/minus 5 to 6 percent cap rate range with the stabilized return in the 7to 7.25 percent range. Concurrently, high leverage and sub-6 percent financing was available to provide enough room to increase returns, albeit not significantly. In today’s market, class-A stabilized product continues to trade within that same 7 to 7.25 percent cap-rate range, but the key term within that statement is “stabilized,” whereas two years ago a premium would have been achieved with the “potential upside” story of the property.
Although media reports continue to depict a declining CRE market, the self-storage industry has continued to post respectable numbers relative to revenues and occupancy. Storage REITs are once again among the top investment performers in 2008 and have shown that our industry is able to withstand a national economic downturn relative to other real estate asset classes.
While increasing storage occupancy and revenue trends may not continue in 2009, they have helped alleviate some of the property-value declines that worry investors. As reports continue to appear showing that CRE values are in decline, just remember that everything is relative.
Minh Tran is a managing director in the Houston office at HFF (Holliday Fenoglio Fowler) LP. He can be reached at 713.852.3524; e-mail [email protected].