Fundamentals in the national self-storage market have remained healthy compared to most other property sectors, including the retail, office and industrial sectors. Asking rents have remained relatively stable at 93 cents per square foot, down only one cent from the third quarter of 2007.
But as we move into ’09, self-storage fundamentals are expected to soften as the single-family housing market continues to deteriorate. Demand for nearly half of the nation’s self-storage units comes from the single-family home transient moving sector—those people moving from one house to another. Consequently, the tremendous downshift in housing sales and new construction impacted self-storage occupancy levels.
In the third quarter of ’07, occupancy was 90 percent, though it dropped 300 basis points in the third quarter of ’08 to 87 percent. Improvement in nationwide self-storage fundamentals hinges upon the length and breadth of the U.S. recession and global economic crisis.
Supply and Demand
Demand has subsided for self-storage units in light of the economic crisis. The investment community believed self-storage was recession-proof, which held true because of the previous limited supply of units. From 1995 to 2005, the number of storage facilities nearly doubled nationwide; however, an onslaught of development changed self-storage market dynamics.
Additionally, in the current economic environment, leasing self-storage space is considered a discretionary expense versus a necessity. When people lose their jobs and houses are foreclosed, storage isn’t a “must-have” or necessity. Instead, individuals must start reducing expenses and storage will be one of those discretionary items that will be cut.
Nationwide, most self-storage owners are experiencing increases in late pays, liens and lower auction proceeds. The prices people are willing to pay now for the items stored at auction are not as high. As a result, owner revenues are reduced as people make late payments. Owners also have more overlocked units and lien sales because self-storage tenants have decided their stored goods are not worth the monthly payment in many cases.
As a result, tenant concessions and delinquencies have increased in the self-storage market, a trend that is expected to continue this year. Currently, public and private self-storage owners are offering tenant concessions at their facilities. Compared to a year ago, when only 30 percent of national owners offered concessions, concessions have increased to 70 percent at national facilities, according to a white paper recently released by Merrill Lynch.
Publicly traded REITs and large owners are outperforming the self-storage market due to their professional management, economies of scale, extensive advertising campaigns and quality of employees. Whereas the national occupancy rate currently stands at 87 percent, occupancy for larger, public self-storage facilities is around 90 percent.
Buyers and Sellers
Despite the slowdown in overall commercial real estate transaction velocity, there are still buyers in the self-storage investment sales market. Overall transaction velocity in the self-storage market dropped 30 percent in the past 12 months while the broader investment market is down 65 to 70 percent with respect to transaction velocity.
Nonetheless, the most active buyers are private investor clients who can more easily access acquisition financing from local and/or regional banks and life insurance companies, while institutional activity has virtually subsided. Many REITs and institutions are digesting the self-storage product they developed or acquired during the frothy years of 2004 through 2006, and are now focusing on operations. For large portfolio sales, there are very few lenders willing to provide acquisition financing.
Now is a great time to be an opportunistic investor in the self-storage market because there is more selection and properties are underwritten on fundamental economics and actual net operating income (NOI), not on pro forma and projections that properties were selling for a few years ago. Investors can achieve low double-digit cash-on-cash returns. Properties selling right now are operating deals clearly underwritten with appropriate reserves, increases in taxes, escalations in insurance with external management and expenses that are optimized for the new buyer.
Between 2003 and 2006, all the risk in a self-storage transaction was borne by the buyer because of the ample liquidity in the capital markets. Whatever the seller wanted, the buyer had to acquiesce. The risk has now shifted to the seller because of the global financial crisis, which has caused yield requirements to increase and resulted in fewer buyers in the market. Many buyers are sitting on the sidelines, believing there is more downside in pricing. As a result, sellers have to be more flexible to deal with fewer buyers in order to close transactions.
The Money Game
Assumable financing has emerged to play a larger role in the investment sales market, and seller financing is making properties very attractive. Nonetheless, financing remains a challenge. Since local and regional banks are primarily providing financing for properties, brokers and the investors they represent should have sound banking relationships. From 2004 to 2007 virtually any investor—no matter how little experience he had in operating self-storage facilities—could obtain acquisition financing; but today lenders are looking for owners with experience, or ones who agree to hire professional management companies.
The gap between buyer and seller expectations remains relatively far apart. It’s imperative that you utilize a third-party representation when entering into a transaction. A third-party intermediary is necessary to navigate the difficult lending environment, obtain optimal underwriting, overcome objections in the current market and find the upside potential that may or may not be obvious.
In the previous years, many brokers became accustomed to order-taking, placing their listings on the Internet and selling them in a relatively short time period. Since that is not happening today, we will see the cream rise to the top and the best brokers will be successful as we move into the new year.
Although investment sales activity has slowed, the stronger self-storage markets are in the Midwest and Northeast. Solid markets include Boston; Buffalo, N.Y.; Northern California; Seattle and Washington, D.C. Well-located, primary market class-A quality construction are still sought after among private investors, and these assets are commanding cap rates of 7.75 percent.
For class-B and C product, cap rates remain in the 9 to 10 percent range, depending on the asset’s location. In addition, a few years ago, there was little spread between the A, B and C product in terms of cap rates and pricing. Now that gap has become much wider. There is much less risk in well-managed, prime, class-A product versus older, privately run and managed facilities that are in secondary and tertiary locations. We expect to see some pockets of softening in markets that were hit hardest by the single-family housing market fallout, including Riverside-San Bernardino, Calif.; Miami and Phoenix.
The success of the self-storage market is tied to consumer confidence and the single-family housing market. To the extent that the housing market improves will determine how quickly self-storage fundamentals will shore up. By all accounts, we have about another year. As the Troubled Assets Relief Program (TARP) and other government bailout programs to infuse some liquidity into the national economy, and as Fannie Mae and Freddie Mac’s operations continue to be streamlined, the more confidence will return to the market.
Steve Ekovich is the national director of the National Self-Storage Group of Marcus & Millichap Real Estate Investment Services. For more information, call 925.953.1716; visit www.marcusmillichap.com.