We remain in a sellers market for self-storage properties, with capitalization rates ranging from the high sixes to the low sevens for high-quality portfolios and single assets. With pricing this aggressive, why are so many new players entering the industry? Capital flow from institutions and individuals as well as low interest rates is keeping the market active, though each prospective purchaser seems to have a different motivation for acquiring properties.
Choosing the appropriate buyer (at the most opportune time) has never been more critical for an owner considering a sale. Following are some important issues to consider when selling a portfolio or single asset.
The Good News
Despite increases in short-term interest rates by the Federal Reserve, the nearterm outlook for self-storage dispositions remains optimistic. Ample liquidity in equity and debt markets, combined with low-cost debt, should continue to support acquisition values and keep downward pressure on cap rates.
Fierce competition among lenders benefits borrowers in terms of low interest rates and flexible terms. The conventional mortgage and commercial mortgage-backed security markets continue to drive the liquidity and low rates. Investor demand for securities is pushing conduit lenders to be more aggressive, creating competition from traditional funding sources. Leveraged buyers will continue to lead the market for pricing in transactions.
As swiftly as capital has flowed into the market, it can just as quickly exit. Negative news such as falling rental rates or even defaults regarding one or more high-profile operators could affect investor sentiment toward the entire sector. A steady rise in interest rates will likely slow activity in highly leverage transactions, as the spread narrows between current cash yields from self-storage properties and the cost of financing. Even a gradual improvement in rents would only partially offset higher interest rates.
Competition from new self-storage development also limits purchasing interest of existing product. Income generated from properties and market values are no longer directly related. Many submarkets previously believed to possess strong barriers to entry no longer have this advantage. New facilities are getting approved in previously high-barrier markets with strict zoning regulations due, in large part, to the emerging sophistication in the aesthetics of new developments.
Types of Buyers
The increasing number of prospective purchasers makes qualifying each buyer more important. There are three distinct types of prospects for portfolios and for select single assets:
- Existing operatorsThis group includes small, medium and large operators and REITs seeking to increase market share and achieve economies of scale.
- New joint venturesThis group includes public and private joint ventures, pension funds, foreign investors and opportunity funds, each with capacity for placing funds from $20 million to more than $200 million.
- New players entering the industry This third group of purchasers continues to expand and includes private investors seeking stable cash yields, 1031 tax-deferred candidates, and prospects seeking diversification from other property types, i.e., multifamily, retail and industrial.
Potential purchasers are now asked to provide in-depth information regarding ability to consummate a transaction. They must be prepared to disclose their source of funds, any approval process to close the transaction, and whether funds are provided through equity or debt sources.
Additional questions concerning debt requirements involve property appraisals. Many appraisers do not possess adequate information of recent self-storage transactions and have difficulty appraising higher-quality properties. Brokers specializing in these types of transactions may be helpful. A prospect may also be interviewed about equity commitments. Questions concerning internal-review committees and allocation amounts are specifically addressed.
Some issues weigh more heavily than others in a prospects decision to acquire self-storage. Owners must be aware of these determining factors to assess the likelihood of closing a transaction without re-trading the price and agreed-upon terms. Some of these buyer motivations include:
Public Offerings. Self-storage operators weighing the future possibility of an initial public offering (IPO) may be motivated to bulk up their total assets to satisfy future public investors. Newly public companies often acquire stabilized properties that are accretive to company earnings. Nonstabilized properties that exhibit the potential to benefit from the companys repositioning expertise may also be considered.
Two companies that completed public offerings in 2004, Salt Lake City-based Extra Space Storage and Cleveland-based U-Store-It, proved to be among the most active bidders for self-storage. Prior to its IPO, Extra Space entered a purchase and sale agreement for the Storage Spot portfolio, with 26 properties and a price of $147 million. U-Store-It also entered an agreement before its IPO, for the 42-facility Metro Self Storage portfolio, listed at $184 million.
Committed Equity. Generally, newly formed joint ventures with previously committed investor equity must place funds quickly or risk losing their backing. Obtaining new rounds of equity is usually predicated on placing the original money. Additional motivation to acquire assets results when a prospect loses to a competitor for product.
Increasing Market Share. Prospects often pursue acquisition of properties in existing markets or those believed to be key to future development. Select assets are targeted in locations believed to complement existing holdings. Prospects also are aggressively pursuing select opportunities outside existing markets to add diversification and economies of scale to current assets.
Evaluating competing offers for any sale has become more complex than ever. A matrix of submitted bids is used to highlight pertinent information for each (see above). Following are some of the categories used for comparison:
- Due Diligence and Closing TimeThe amount of time a prospective purchaser requires for physical, financial and legal due diligence is critical. A long duediligence period inherently increases risk associated with successfully closing a transaction. Debt and equity requirements can also change quickly in a dynamic market.
- Earnest MoneySignificant earnest money deposited into escrow may be a gauge of a prospects good faith, but the point when earnest money becomes nonrefundable distinguishes the best prospects.
- Financing ContingencyThe significant capital recently committed for self-storage makes this category even more important to sellers. Any offer requiring a financing contingency is less desirable than noncontingent offers. Prospects without a contingency may require fewer approvals for funding and, theoretically, close a transaction more quickly.
- Cash vs. Operating Partnership UnitsCapital-gains taxes are often a significant financial consideration for owners with a low basis in their properties. Public companies with an UPREIT structure provide a potential advantage by allowing owners the opportunity to contribute their properties in tax-deferred transactions using Operating Partnership (OP) units in lieu of cash. The OP units are similar to shares of stock in the company and do not trigger a taxable event until they are sold, while offering potential appreciation in their value.
- Seller FinancingOccasionally, purchasers will request the seller finance a portion of the purchase price to help achieve their projected target internal rates of return. Seller financing on select portfolios can be 10 percent to 25 percent of the purchase price. It helps to bridge gaps from insufficient loan proceeds with lower costs.
- Section 1031 Tax-Deferred ExchangesPrivate buyers seeking to consistently defer their capital-gains taxes are excellent prospects for primarily single-asset acquisitions. Many of these candidates are not initially aware of the specific management requirements of self-storage.
Every owner has myriad issues to consider when selling his property. But due to the vast amount of capital available, coupled with low interest rates, it has never been a more opportune time for owners to consider selling a portfolio or single asset.
Marc A. Boorstein is a principal with Chicagobased MJ Partners Real Estate Services and has been involved in the purchase, sale and financing of more than $500 million in real estate nationwide since 2000. Mr. Boorstein is a regular speaker and author concerning the trends within the self-storage industry. He can be reached at 312.726.5800 or [email protected].