If you’ve been paying attention to self-storage real estate listings, you may have noticed that “distressed” facilities are being marketed more frequently. This used to be rare because most investors didn’t want these kinds of assets. The term usually meant that a facility was older and underperforming due to reasons within a trade area that a new owner might not be able to fix.
However, due to the building craze that’s been taking place in our industry since 2015 as well as the impact of soaring interest rates and construction prices, there’s a new breed of distressed property on the self-storage market, and it can offer investors valuable upside worth pursuing. Let’s explore the properties that fall into this category, the root of their problems, and why they can make a smart buy.
What Qualifies as ‘Distressed’ Today
Many of the self-storage properties offered for sale these days are newly built sites that have recently received Certificate of Occupancy. Historically, these would be the furthest thing from “distressed,” and yet the market indicators suggest they are. Why? Because the bank or the numbers say so.
In many cases, these assets are upside down, meaning their owners owe more on the property than it’s worth. For example, I saw a 50,000-square-foot facility that had been underwritten at around 4% interest and most likely a 5% or 5.5% capitalization (cap) rate for reversion pricing to get the construction loan. The whole thing was built at once rather than in phases. As a result, after one or two months of operation, it was only about 5% physically occupied, with an economic occupancy of 1% to 2%.
If we extrapolate the potential income of this facility at its current asking rental rates, assuming 85% occupancy, it would be worth $2.7 million to $3 million. It probably cost north of $4.2 million to build. In the current state of the market, this is what a distressed self-storage project can look like.
Why These Assets Underperform
There are two main reasons why this is happening today: The shift in the economic landscape and overbuilding. In fact, we should expect to see more properties like the above eventually hit the market.
If self-storage has a downside, it’s that development occurs in slow motion. It takes about a year to get project approval and then another six months to a year to build. Lease-up can then take another two and a half years to stabilization. That means it can often be three to five years before a return on investment is generated.
If you’re the developer, what happens if your interest rate doubles during this period, rental rates fall 15% to 20%, and future value shifts from a 5.5% cap rate to 7%? Well, you wind up with a distressed property.
Add to that, some investors have been overzealous. After they bought all the 5% cap-rate properties they could find, they started building—and they built big. A lot of these construction loans are now running out, and banks are reassessing the projects they want to fund. In addition, there are a lot of self-storage facilities that have to refinance their original five-year loans.
My industry experience from 2008 tells me these investors will have to inject more cash into their projects or sell, and many will choose to sell. So, be aware: In the 2020s, distressed self-storage properties can be shiny and new.
The Artful Buy
There’s an art to acquiring these new yet distressed self-storage properties at good prices. Often, you’ll be dealing with the lender as well as the seller. Anybody remember the term “short sale” from the 2008 real estate mess?
The smart way to buy one of these assets is to run your lease-up analysis using real rental rates (current rates or something like 10% less than the going rate) at current absorption numbers. If a facility has been open for two months and it’s 2.4% occupied, your absorption rate is 1.2% per month. Don’t use the number you think you can achieve. Use what is happening.
Next, using the same metrics, determine what the project will be worth when it’s stabilized at a 7% cap rate. Base your offer on the profit you need or want, knowing that value number. If you’re savvy, you can create a lot of wealth during a time like this.
For example, I know an investor who did very well during the last big downturn. His approach was to go to the bank that was holding the loan on a distressed asset and tell them what he could pay and why. Though they didn’t particularly like what he was saying, they understood his viewpoint. He’d say something like, “If you’ll allow me to buy this property at the real value, and you provide the loan, I’ll buy another project on which you’ve had to foreclose and get it off your books. Oh, and I’ll also need a loan on that one, too.” Using this strategy, he’d get two assets at once.
You can do something similar in today’s market. If you have a loan rolling on a good property with a low loan-to-value, approach the bank to get the loan on that facility (a safe deal for the bank) in exchange for letting you buy a second, distressed asset at the value you need.
Think benefits. What can you offer the bank or seller and still get the reward you need to do the deal? If a seller isn’t in enough pain yet, just wait. If someone else steps in and is willing to pay more, let them. There will be more deals like this down the pike.
Now’s the Time
Remember, we’re only limited by our creative thinking. Many investors and owners have known only one way to be in the self-storage business—during boon times, when things are blowing and going. Now’s the time to be cautious but ready to pounce.
The industry has never experienced a downturn with so much existing inventory in this many major markets and trade areas with rental rates trending downward. This new reality creates buying opportunities, and the benefit of being a small investor is the ability to pivot quickly. My hope is for many of you to pivot into some really exciting self-storage buying opportunities in the near future.
Mark Helm is a commercial real estate agent and self-storage investor. He began working with real estate investment trusts in the mid-1990s to locate and purchase self-storage properties before striking out on his own. He’s the author of “Creating Wealth Through Self-Storage” and the creator of “Storage World Analyzer,” a cloud-based, financial-analysis software tool designed to help self-storage operators and investors evaluate potential real estate acquisitions or development projects. To reach him, email [email protected].