By Isaac Rothermel
Self-storage has become an increasingly popular investment, in great part due to returns that have averaged 15.43 percent during the last 15 years. For many investors, self-storage can seem easier to understand, with less moving parts, compared to other avenues. In addition, development has become more popular as the price for existing facilities has risen and demand for individual units increased.
With the majority of self-storage facilities owned by “mom and pop” operators, new listings are always coming to market. That being said, a continuing trend in the industry is consolidation, with real estate investment trusts and mid-size operators competing for market share. Now is the time to buy a property, before more of the individual facilities are absorbed by chains.
The Tale of Two Properties
If you’re considering an acquisition, putting an investment strategy in place is paramount. Often a property may be a sound investment for someone else but you’d be better off ignoring it. Let’s look at two example properties assumed to be the same price:
The cap (capitalization) rate is the return on investment (or ROI, after expenses) a buyer would receive if he paid all cash for the property. In other words, the net operating income (NOI, which includes all income minus expenses) divided by the sale price equals the cap rate. In looking at ABC Property, if the buyer paid all cash, he’d receive a 5.5 percent ROI. XYZ Property, on the other hand, offers a return of 9.5 percent for an all-cash buyer. The more you pay for a property—assuming NOI stays the same—the lower the return. Conversely, the less you pay for a property, the higher the return.
With that in mind, it probably seems like XYZ Property is the easy choice since it promises the higher ROI. All you need to do is install new doors, hire a quality manager, implement basic operation best practices, reduce vacancy, raise rents to competitor levels, and build out the 20,000-square-foot expansion. Simple, right?
Well, not so fast. While many management practices are relatively easy to understand (maintain an online presence, collect past-due rent, offer rent concessions to acquire tenants, set up a tenant rate-management program), implementing them is typically time-consuming and stressful. If you’re buying XYZ Property at 70 percent occupancy and you have to begin the eviction process on 20 percent of the property, you might see occupancy drop to 50 percent before it goes back up.
So why would someone want to buy ABC Property if it has a cap rate of 5.5 percent? The main reason is because there’s less risk and work involved. If all you need to do is run the business the same way the previous owner did to achieve the same results, that’s a pretty minimal amount of work for a decent return. Consider as well that if the investor who purchases ABC Property is also able to buy several other similar properties in the same market, he’d likely be able to sell the entire portfolio to someone else for a lower cap rate, perhaps 5 percent.
If you have a portfolio that cost you $20 million to purchase, with the individual properties at a 5.5 percent cap rate, and you sell it at a 5 percent cap rate, the price for the entire portfolio would be closer to $22 million. That’s a 10 percent improvement in value just for aggregating several properties into a single portfolio.
Additionally, ABC-type properties are much easier to sell than those reminiscent of XYZ. The buyer pool for ABC properties typically has more available cash and can borrow at lower rates. If you buy XYZ Property with the plan to improve management, significantly increase value and then sell to cash in on your work, you may find it very hard to sell the property, especially if the overall market isn’t favorable.
A Step Up in Class
Another common investment strategy is to buy properties in C-class condition and physically improve them to A-class condition. This improves value in two ways: It raises rents the market will support for your property and lowers the cap rate for which your property would sell. This strategy requires construction know-how and is capital-intensive, but it can be very lucrative if done properly.
In some ways, this is very similar to “flipping” a house. It includes cosmetic and system improvements, such as repainting the buildings, installing an electronic gate system, or installing HVAC to convert units to climate control. It also potentially repositions the property through techniques like improving road-front visibility by obtaining a variance to clear trees from in front of the building or other measures.
There are endless variations to these investment strategies to improve the value of a self-storage property. Determining which plan is right for you will depend on your available time, cash and risk aversion. Picking a strategy is the first step in buying, as it will help you quickly evaluate and make decisions on properties as they come to market.
Isaac Rothermel is a broker advisor at Investment Real Estate LLC, which has provided brokerage, construction, management and development services to self-storage owners and investors since 1998. For more information, call 717.779.0804; e-mail firstname.lastname@example.org; visit www.irellc.com.