By Jeffrey Turnbull
The self-storage industry has benefited tremendously over the past several years from the low interest-rate environment, the slow but continued economic recovery, the explosive growth in multi-family housing, and the limited supply of new development. It’s no secret the asset class is receiving tremendous investor interest.
This attention from individual investors as well as real estate investment trusts (REITs) is driving facility values to new highs. In fact, in many markets, our niche industry may be approaching the top of the current real estate cycle. Now could be an opportune time to sell, or at the very least, begin to review your exit strategy.
When you constructed or purchased your self-storage property, you probably included some type of exit strategy in your business plan. It may have been as simple as, “I’ll sell when I reach a certain age, or when I achieve a certain return.” A more formal plan would be set out in the context of the self-storage business life cycle, comprised of three phases: the development phase (beginning), the expansion and operation phase (middle), and the maturation phase (end). Let’s take a look at how these might relate to your situation.
A proper exit-strategy analysis will first examine where your business is in its life cycle. For example, is your store facing competition, with the success of rate increases unlikely? Have you begun to see the immediate market deteriorate economically? Is it impossible or difficult to expand your business by adding square footage? These factors may indicate your property is in the mature phase.
On the other hand, are you able to continue raising rental rates? Do you see an influx of new housing with higher incomes in the area? Do you have additional land for expansion? These factors indicate your business hasn’t yet matured and is still in the growth stage.
You need to pinpoint where your business is in its life cycle and then determine the factors prompting your exit strategy. The superior seller’s market notwithstanding, a life event such as divorce, illness, death of a partner or even age can be the single greatest motivator to sell or transfer ownership of your self-storage facility. If you’re not considering an outright sale, do you have a succession plan? Is it part of an overall long-term estate plan?
Even though market conditions are favorable to sell or transfer ownership of a facility, to maximize your total return on investment, you need to make sure your business is at or near the mature stage, and your own life events make an exit strategy appropriate. Below we’ll review the three basic exit strategies.
1. Outright Sale for Cash
This sale for cash is as simple as it gets. Hire a competent real estate broker with experience in selling self-storage properties and allow him to represent you in an all-cash sale. The process shouldn’t take an unreasonable amount of time, depending upon your specific facility, the local market and your expectation in terms of price.
The major issue is the payment of capital-gains (long term) and ordinary income (recapture of depreciation) taxes on the transaction. It’s always be wise to consult with your CPA prior to the transaction becoming final to assess the tax consequences of a sale.
2. Tax-Deferred 1031 Exchange
This process allows you to exchange your self-storage facility for another real estate asset of equal or greater value, and defer all the taxes on that exchange, so long as you meet the requirements of section 1031 of the Internal Revenue Code. This is a complex transaction that requires your real estate broker, an attorney and, normally, a qualified intermediary to handle the proceeds. The 1031 exchange has very specific rules and timelines to follow.
This strategy is useful when a self-storage owner wants to move into a different real estate asset class such as an office building. If structured correctly, it allows the deferral of the entire gain and ensuing tax consequences related to the transaction. One of the main goals in this type of transaction is to reduce the day-to-day management obligations while preserving the income stream from the new asset. The tax on the gain will only be recognized when the asset is eventually sold for cash at a future date.
3. Deferred Sale UPREIT
In this strategy, a self-storage owner can typically contribute or transfer ownership of his facility to an umbrella partnership real estate investment trust (UPREIT) in exchange for partnership-operating units. This type of transaction (contribution of property for a partnership interest) is called a section 721 exchange (Section 721 of the Internal Revenue Code).
At this point, the exchange isn’t considered a taxable event. In essence, the self-storage owner becomes a limited partner and is entitled to receive distributions—normally taxable as ordinary income—from the UPREIT partnership units. A REIT will be formed, or is already in existence, to act as the general partner. The owner has the ability to convert his partnership units into fully marketable REIT shares at some point in the future, normally after one year. This conversion will be treated as a taxable event but does provide liquidity. In effect, you’re achieving a diversification of your asset, maintaining an income stream and liquidity. Of course, you’re giving up control.
The UPREIT structure can also dovetail nicely into an overall estate plan. The partnership-operating units can be converted to fully marketable REIT shares with a stepped-up basis at the date of death of the owner, thus no gain from the original transaction will be recognized.
So, you can “cash out” of your self-storage business in a variety of ways—all cash, exchange to a different asset class, or for individual partnership interests and, ultimately, shares in a REIT. Note the safety and simplicity of the all-cash transaction, but with potentially high tax consequences, and the tax-deferral advantages of the 1031 exchange and UPREIT options. Only you can decide which strategy to follow when it’s time to exit your business, based on your exact needs, appetite for risk and understanding of each process.
Note: Before attempting any of the strategies discussed in this article, consult the appropriate legal, tax and real estate professionals.
Jeffrey Turnbull is president of Kodiak Mini Storage LLC. He’s been involved in the self-storage business as a developer, operator and owner for more than 20 years and currently owns three stores in Charlotte, N.C. He’s a licensed attorney in North Carolina, a licensed real estate broker in North and South Carolina, and a past president of the North Carolina Self Storage Association. Mr. Turnbull is a regular contributor to “Inside Self-Storage” and a speaker at various industry events. To reach him, e-mail [email protected].