By Aaron Swerdlin
Due to current circumstances surrounding the capital markets, there are tens of millions of dollars of equity looking for a home in the self-storage space. A joint venture can be a great way to leverage equity, benefitting both the equity and operating partners.
Commercial real estate transaction volume is very healthy, and transactions in core markets are at very high levels against the five-year average. Almost five years of sustained low interest rates has a lot to do with the obvious conviction behind the steady volume. The current market is also benefiting from a plethora of capital on the equity side.
The low interest-rate environment permeates the investment world. A general lack of meaningful yield available in lower-risk vehicles forces all investors to get creative and expand their universe. No-risk investors, if there is such a thing, generally focus on a portfolio of Treasury bonds. But with near-zero percent yield on short-duration bonds and going out as far as 30 years for a less than 4 percent yield, the lowest-risk, fixed-income investors have broadened their field of vision. Every time an investor class broadens its risk tolerance, supply-an-demand fundamentals compress yield across the spectrum, and those seeking higher yield are displaced to a higher point on the risk curve.
This is one of the principal drivers behind the Federal Reserves bond-buying program. By strategically buying around $85 billion of bonds every month, it's able to strategically displace yields. Theoretically, what the Fed chooses to buy each month is at a higher price (lower yield) than what the next guy in line is willing to pay, so he has to go elsewhere for that yield. Not only does that compress the yield on the bonds the Fed purchases, it sends that next guy to a different duration bond or maybe even a different asset class.
This is why the Feds decision regarding when and by how much to taper its bond-buying program is so critical to pricing. By beginning to remove the artificial compression, the interest-rate market will slowly settle into a supply-and-demand pricing model thats conditioned solely on its own merit.
As the Fed tapers its monthly bond buying to zero, the pricing across all assets classes and the full spectrum of risk will become more fluid and arguably more predictable. Certainly, some of the taper is priced into the market. But the speed with which the Fed reaches zero will have everything to do with how large swings in pricing toggle and the volatility with which those swings occur.
Bringing all this back to commercial real estate, and specifically self-storage, the volume of equity looking for yield has an all-time high amount desirous of landing in the self-storage space. Undeniably, self-storage transaction volume is at very elevated levels relative to historical averages. The most active buyers by volume have been the real estate investment trusts (REITs). But the most active by number of transactions have been the privately held companies.
Driven by those seeking yield, the performance of the self-storage public equity market has been remarkable. It has reinforced that the industry is a valid asset class among investment real estate; that operationally its extremely resilient against a recessionary environment; and comparative operations against other product types gives the nod to self-storage every time.
This has enabled the REITs to finance much of the sectors transaction volume through equity placements, debt placements and preferred and perpetual preferred equity offerings. With ample demand for equity, they will be able to continue to finance their activities from a wide swath of resources. In some cases, theyve joint ventured with private equity firms to acquire portfolios.
In this structure, the REITs bring some of the equity to the transaction, with the joint-venture partner bringing the balance. Structures vary widely, as do the motivations. Generally, it enables REITs to leverage their equity into a greater volume of transactions and dilute risk. They also bring their brand and operating platform to the entire transaction, which gives them more scale and spreads general and administrative costs across a wider portfolio.
Joint ventures dont only benefit the REITs. In fact, local, regional and even national privately held companies have more opportunities than ever to enter joint ventures. There are tens of millions of dollars of equity looking for a home in the self-storage space. A lot of equity firms representing this money are not yet invested in the product type, so they tend to be very open minded with regard to opportunities.
Joint ventures are a great way to leverage equity. Just like the public companies, the operating partner benefits from branding, operational-expense scale and market share as if it owned the entire property; and it accomplishes this with less than 100 percent of the equity.
Because transaction opportunities tend to be limited, with volume not coming anywhere close to matching demand, most joint-venture equity partners look to place as much as 95 percent of the equity in acquisitions and as much as 85 percent in development deals. In core urban markets, whether its an acquisition or a development, some look to provide as much as 97 percent of the equity.
Of course, there are issues regarding control, decision-making, property management and other issues that some privately held companies want to avoid. But generally, when interests are properly aligned, joint ventures enable operators constrained by limited equity to grow at speeds much faster than they can grow organically. As the joint-venture equity partner gains comfort and confidence in its operating partner, broadening the geographic focus of a partnership can further widen the scope of opportunity.
The Long-Term Outlook
As the investment world continues to navigate this low-yield environment and the supply-and-demand fundamentals get closer to functioning without a Fed bond-buying program, the risk-to-return expectations for all the capital in the system will adjust. Allocations away from perceived riskier assets will shift back to perceived safer assets, which could impact commercial real estate at some level. However, as long as the adjustment is measured and not instantaneous, its likely accompanied by stronger inflation, which will benefit asset classes like real estate.
Self-storage is poised to continue to outperform, as its not bound by rental rates tied to long-term lease obligations. Only hotels can put on inflation to its bottom line faster, as it prices its product daily rather than monthly. A very comfortable, long-term outlook and strong expectation for the self-storage industry is excess capital will continue to provide multiple structures that promote growth and flexibility to pursue opportunities.
Aaron A. Swerdlin is an executive managing director in the Houston office of NGKF Capital Markets, a group within commercial real estate advisory firm Newmark Grubb Knight Frank. Best known for his self-storage property expertise, Mr. Swerdlin has 20 years of experience in capital markets and serves as NGKFs national practice leader for the self-storage sector. To date, hes led in excess of $4.3 billion in self-storage transactions and more than $4.8 billion in overall transaction volume. To reach him, call 713.599.5122; e-mail [email protected] ; visit www.ngkf.com/storage .