As the self-storage industry basks in its recent success, once again we’re on the upward swing of an improving, if not peaking, investment market. This leads me to recall maybe the most relevant statement made to me over the years by my company’s founder, real estate expert Mike McCune: “It’s easy to get in a dealyou write a check. But it’s how you get out that matters.”
As the industry has matured and sophisticated, facility owners now have a number of exit strategies available to them. Below are just a few to consider when selling or repositioning your self-storage assets.
Outright Sale/1031 Exchange
This is the old-fashioned way of capitalizing on your investment. You engage an expert in selling self-storage properties to advise you on recent sales comparisons and the market value of your particular asset. You then market the property to a wide range of investors and choose from the most-qualified and well-capitalized buyers. This allows you to sell your property, pay the required capital-gains tax and move on to your next investment. This is still a valid and very good option for most investors and typically results in the highest rate of return for the property owner.
However, many sellers don’t want to pay capital-gains taxes, so they consider a 1031 exchange. This is a section of the IRS tax code that provides a process for sellers to defer their capital-gains taxes if they buy a like-kind property of equal or greater value. The 1031 process has many rules and regulations a seller must obey, but it can be very lucrative if done right and the exchange property performs well in the years to come.
However, I must offer a word of caution. It seems many sellers today feel so strongly about this tax deferral that they’ll only sell their property if they can participate in a 1031. The determination of whether an exchange makes financial sense is complex, so contact your tax advisor to analyze your particular situation and understand the current market conditions and risks. Below are just a few points to consider when contemplating a 1031 exchange:
- Will you overpay or make a poor decision with regard to the exchange property due to the time limits involved and the current market conditions?
- Will you lose bargaining power in the sale of the relinquished property or acquisition of the exchanged property due to the time pressures associated with the exchange process? Inevitably, it comes to the forefront that the buyer/seller is in the 1031 process, and this will have a meaningful impact on the deal.
- The adjusted tax basis of the relinquished property is carried forward into the exchanged property. What is the effect of the lower cost recovery (depreciation) available as a result of the 1031 exchange?
- How much flexibility could be lost by participating in a tax-deferred exchange, and what will the capital-gains tax rates be when they’re ultimately paid?
A thorough analysis of the 1031 process and overall market is of great value in deciding whether to pursue a tax-deferred exchange.
The values of all storage properties have surged to record levels over the last 12 to 24 months. This has put many owners in a position to have their cake and eat it too! Depending on when you acquired your property and what your cost basis is today, you may be able to use some structured financing to achieve the best of both worlds. If you purchased your facility before 2004 or between 2008 and 2011, you’re most likely in a position to capitalize on the very fluid debt market and take advantage of a once-in-a-real-estate-cycle opportunity.
With values increasing 30 percent or more in most cases from 2010 to 2014, many owners who purchased properties in the above-mentioned window are in a positon to refinance their assets, receive cash out in the amount of their initial capital investment and still own the properties. If you’re fortunate enough to have purchased a facility that experienced greater than 30 percent appreciation due to capitalization-rate compression and improved net operating income, you may actually receive financing proceeds that exceed your invested capital.
Refinancing proceeds are tax-deferred. This allows you to take the cash and grow your portfolio by purchasing another property, developing a new one or paying off high-interest-rate debt—all while continuing to own and operate your original asset.
This probably sounds too good to be true, so here comes the “fine print.” Much like a 1031 exchange, the money you receive on cash-out financing will be subject to taxes at some point in the future. My advice is to consult with your tax advisor and fully understand the situation before buying that new car or second home.
The self-storage real estate investment trusts (REITs) are growing very aggressively, and most have the ability to offer operating partnership (OP) units as compensation to a seller in lieu of cash. When a REIT operates as an umbrella partnership (UPREIT), investors have the ability to own OP units, which represent limited-partnership interests in an operating partnership that owns the properties. Typically, OP units are convertible to common shares and have the same dividend and stock-price volatility (up or down) as common shares of the REIT.
The benefit of OP units is the structure allows the seller to defer the tax liability until exchanging it for REIT shares or cash. In most cases, you must wait a year to redeem OP units. This creates diversification, gives sellers some flexibility in regard to how to receive proceeds from a sale— all cash, all OP units, or a mix of cash and OP units—and allows for a liquidly event in a defined time frame, which allows for tax and estate planning.
Taking this topic one step further, OP units can be used in a variety of ways, such as being pledged as collateral for a loan, much like margin account. For larger and more complex deals of $20 million or more, it’s also possible to structure a hybrid of common and preferred OP units.
Obviously, the devil’s in the details, and you should speak with your tax advisor if you’re considering an UPREIT or OP-unit deal. These types of deals have shown there’s a more valuable currency than cash, and that is an ownership interest in a very well-run and growing company. We’re fortunate to have several of these in the self-storage industry that can provide you structures such as those mentioned above.
As we continue to enjoy and experience the latest run in self-storage values, one thing to remember is timing is everything in the real estate business. It’s better to be a year too early than a day too late!
Ben Vestal is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self-storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE; e-mail [email protected]; visit www.argus-selfstorage.com.