The stage has been set for some investors to capitalize on a once-in-a-lifetime opportunity while others feel the pain of having made poor investment decisions, falling victim to predictable errors such as “excessive optimism or overconfidence.”
Over the last several years we’ve seen the accelerated awareness and acceptance of an industry that, until recently, was referred to as the “stepchild” of real estate asset classes due to its lack of transparency and standardization. In recent years, investors, lenders, appraisers and consultants all made decisions to invest in self-storage believing their respective facilities could capture a disproportionate share of a market’s self-storage demand.
This frenzy of investment was augmented by several sources of low-cost capital made available to many borrowers with little or no self-storage experience. The dearth of information helped to create an “imperfect” marketplace where knowledgeable investors took advantage of less informed ones who came to this market with unrealistic yield expectations.
Act I: The Problem
It’s not the self-storage market that’s the problem for many of today’s investors; it’s the “deal” that some investors made. Many who acquired facilities within the past few years paid the highest prices in the history of the industry, and did so having given little or no consideration to the differentiation in risk between types of facilities and locations.
Soon, many of these investors will face loans that are coming due on facilities they overpaid for and over financed. Given the tighter underwriting standards of today’s capital markets, it means these investors will most likely be required to put additional equity (hard dollars) into the deal. Some will be forced to sell, creating more opportunity for others.
Act II: The Opportunities
Sports fans have a saying, “Let the game come to you.” That’s exactly what many astute self-storage investors have been doing ... waiting. Now, the market is coming to them and we will all see them stepping up to the plate.
Those who have been in real estate for a while may recall the origins of national hotel chains, such as the Hilton and Sheraton, began during the stock market crash and depression of the 1930s, when entrepreneurs took advantage of financially distressed hotels.
Experienced self-storage investors, who understand market fundamentals are strong and who have been waiting for the market to come to them now have an opportunity to expand their holdings by acquiring facilities from financially strapped investors.
Act III: The Conflict
When the markets were stronger and values were increasing rapidly, no one noticed or cared that appraisers and lenders often used class-A cap rates to value class-B and -C facilities. Unfortunately, this sting of confusion will be felt by many in the current clime:
- Tax assessors who use sales of superior quality facilities (those achieving the highest rents in central business districts) to derive the assessed values of facilities with functional obsolescence located on secondary streets in the suburbs.
- Facilities being underinsured because appraisers based their values on inferior quality construction of single-story frame structures to value high-rise masonry structures.
- Owners whose facilities are undervalued by lenders using sales of inferior facilities with higher risk, not reflective of the subject’s high-barriers-to-entry and superior quality of construction.
- Appraisers using the expense comparables derived from sales of investment-grade facilities in major cities (which have much higher expense ratios) to value an owner/operated facility in the suburbs or even rural locations.
- A consultant who determines a proposed project is feasible because he assumes that all facilities are created equally.
For these and a host of other reasons, all other real estate sectors have recognized the need to classify properties by type and location. For instance, many are familiar with office buildings ranked as class A, B or C, or the difference between luxury, standard and economy lodging facilities. There is no confusion about the difference in value of a regional shopping mall and a neighborhood center. Nor would anyone would expect a garden-office complex to be comparable to a high-rise office located in the heart of the city. For the same reason, why should an investor in self-storage think all self-storage facilities perform in a comparable manner and reflect the same risk?
The quality of construction, location, accessibility, visibility, the level of professional management and many other attributes differentiate self-storage facilities and have a direct bearing on the risks they face. The following definitions are offered as a guide in hopes the self-storage industry recognizes the importance of classification and standardization of terminology.
Class-A facilities. Class-A properties feature excellent locations and access that attracts tenants willing to pay rent in the upper percentile of the market. The facilities must be of superior construction and finish, relatively new or competitive with new facilities, and provide professional onsite and offsite management. These are typically located in markets with high barriers-to-entry. They are characterized by above-average maintenance and security systems.
Class-B facilities. Facilities with average locations, access and visibility earn a class-B distinction. These sites and the rents they collect compete at the low end of class-A facilities and above the class-C facilities. They receive average-to-good maintenance and have a full-time onsite manger and competent offsite management. The quality of construction and security systems ranges from average to good.
Class-C facilities. These sites generally have secondary (less desirable) locations relative to the tenants’ needs. Often they have poor access and limited visibility. They are typically older facilities with growing functional and/or economic obsolescence. They achieve rents at the bottom of the range in the market, are often owned and operated by individuals, and may not have an onsite manager. The quality of construction and maintenance ranges from fair to average. Often these facilities have minimal or no security and receive below average maintenance.
Since the industry has not developed its own standard for classifying facilities, and given the new underwriting standards and the stricter due diligence going forward, we can expect lenders will develop their own classifications.
The need for standardization of terms within the industry is obvious and long overdue. It is particularly important at this stage of the industry’s maturity that lenders, investors, appraisers and analysts understand that not all self-storage facilities face the same risks, even within the same market.
The industry’s current overall strength is weakened only by the few investors, appraisers and lenders who did not or chose not to acknowledge the differences in risk that are directly attributed to differences in the quality and location of facilities.
Charles Ray Wilson is founder of Self Storage Data Services Inc., an independent research firm that maintains the nation’s largest database of self-storage operating statistics. He is an internationally recognized leader in providing independent research on the self-storage industry. For more information, visit www.ssdata.net.