From the outside looking in, the Canadian self-storage market looks great. But once you start getting into the unsexy details, things seem to lose their rosy patina pretty quickly.
Without a doubt, the sector has weathered the COVID-19 pandemic well. With a little reflection on the past year, it makes sense. Self-storage use is largely fueled by all the Ds: death, disaster, divorce, dislocation, downsizing, etc. All these triggers have grown at an unprecedented level, and Canadian self-storage operators are benefiting. Even so, the industry faces several obstacles to growth moving forward. Let’s examine them.
On the positive side of the pandemic impact, we’re seeing increased self-storage demand, record-high occupancies and strong rental rates, all of which lead to higher revenue and, therefore, higher facility values. On the flip side of that are high capital-gains taxes.
Self-storage real estate transaction volume has always been low in Canada. This is partly because there simply aren’t that many facilities. In fact, there’s fewer than 3,000 nationwide. But it’s also because the capital-gains tax can be staggering. It’s hard to convince somebody to sell a facility when they’re going to pay what can feel like punitively high taxes. This is unless the sale price is correspondingly elevated to compensate. From that perspective, current conditions may make it easier for owners to pull the trigger on a sale; but how long will they last?
Even though real estate values for self-storage facilities are at an all-time high in Canada, consolidation continues. Large operators with considerable economies of scale are purchasing smaller ones. They can leverage their technological advantages and share expenses over several facilities in a single market to make these acquisitions accretive and meaningful to their portfolios.
However, this poses significant challenges to the remaining smaller operators, who are being crowded out of the valuable first page of Google searches and falling further behind in terms of technology and advertising. This isn’t so much of an issue at the moment, with occupancies being at an all-time high across most primary and secondary markets; however, it does pose a risk if occupancies start falling and the amount of newly developed product increases. This gap could pose a real threat to single-facility owners and make it difficult for them to compete.
This risk of increased competition could put downward pressure on occupancies and rates and increase the pace of consolidation. But if independent owners want to hold their facilities as generational assets, it might lead to an increased use of third-party management services, which allow them to leverage economy of scale without having to sell. Often, the advantages offered by management firms outweigh the fees they charge. They allow an owner to make more money without having to manage the day-to-day operation. Plus, owners can maintain their business for future generations while avoiding the capital-gains tax from selling the golden goose.
Increasing Property Taxes
What all Canadian self-storage operators need to understand moving forward is how to navigate property-tax appeals. Governments have been spending freely and aggressively as they do their best to facilitate economic recovery. There’s no shortage of speculation that property taxes will be targeted in the coming years to compensate for this increased outlay.
We’ve already started to see local authorities increasing property taxes, sometimes drastically, and leaving it up to self-storage owners to appeal them. It can take up to five years just to schedule a hearing! This is significant, as owners responsible for paying the increased taxes until the hearing, and there’s no guarantee of winning the appeal or getting a refund. In the years to come, every owner will need to become good at navigating the appeal process or get somebody on their side who knows what they’re doing.
One item of particular concern is that various tax authorities are looking at shifting the property taxes for self-storage from the cost approach to the income approach. This has been a persistent threat to the Canadian industry in recent years, as property taxes calculated via the income approach could increase the bill up to 40%, which could result in the forced closure of many facilities. The Canadian Self Storage Association has been lobbying against this change for 10 years with some success. However, the threat continues to loom, and all owners and investors should be aware of it.
The other tax threat is the active vs. passive debate, which affects small operators. If you haven’t heard of this and want to invest in the Canadian self-storage market, you need to get up to speed. Basically, to be considered an active business, which allows you to access the lower, small-business corporate tax rate, your storage facility must have a minimum of five full-time employees who are not family members. This poses a real and material threat, especially as the government looks for ways to generate additional tax revenue.
More Development Fees
Another area the Canadian government seems to be targeting for additional revenue is development. Ground-up construction is already expensive because costs continue to rise, but development fees can make new projects impossible. Essentially serving as another tax, these fees have risen to more than $40 per square foot in some municipalities.
Adaptive reuse or conversion of an industrial building (self-storage is considered an industrial use across most zoning designations in Canada) voids these fees through credits on existing square footage. However, it poses a different challenge because with the industrial vacancy rate in the Greater Toronto Area (GTA) at 2.1%, among the lowest in all of North America, industrial product is extremely expensive. This includes the obsolete product with low clear heights that make for great storage conversions.
All this being said, Canadian developers are resilient and continue to find ways to make new projects pass hurdle rates, especially in Toronto and surrounding areas. While estimates are never perfect, I’m tracking nearly 8 million square feet of potential development in the GTA, Hamilton and Toronto, which represents just over 1 square foot per capita, with a population of about 7.7 million people. This new product will add about 33% to the current inventory, and all within a relatively short period. So, even though the total square feet per capita remains relatively low, it would be reasonable to assume that lease-up will be slower than we’ve seen in the past. Rental rates will also experience some downward pressure until stabilization is reached.
Where There’s a Will
All the above factors combined form a pretty tricky environment to navigate in Canada. Buying and selling self-storage is complex because capital-gains taxes can feel punitive and facility prices need to be correspondingly high. New projects are being challenged by charges that make it difficult for developers and owners to meet their hurdle rates. Furthermore, the adaptive reuse of obsolete industrial buildings is being tested due to low vacancies and extremely high prices.
Still, when there’s a will, there’s a way. Despite these trials, the self-storage industry in Canada continues to thrive. It may just not be as simple as it seems from the outside looking in.
David Allan is vice president of development and acquisition for Apple Self Storage, which operates 36 facilities in Canada. He joined the company in January 2014 and has been primarily responsible for growing its portfolio through acquisition, development, joint ventures and third-party management partnerships. He’s been responsible for adding more than 1.5 million net rentable square feet and has been involved in more than $400 million in completed developments and acquisitions. For more information, 866.880.6698; email [email protected].