After reviewing the year’s financial reports from the self-storage real estate investment trusts (REITs) and hearing feedback from self-storage owners, I’ve concluded that the industry is doing pretty well in this Draconian economic climate. After the first quarter of 2009, most of the REITs were very close―or, in some cases, even a little ahead of the game―to their revenue and net operating figures from the first quarter of 2008.
A recent survey of self-storage owners revealed that very few are having serious problems with operating revenue where their markets are stable, although delinquencies are up somewhat. On the other hand, few owners were experiencing much growth in revenue or rental rates. Many new properties are leasing up slowly, which probably indicates that new rental demand is generally weak. Existing renters are more willing to stay put, but prospects are less likely to rent.
Despite the industry-wide belief, self-storage is more recession-resistant than recession-proof, but even that’s really good for our team.
The Real Estate Side of Self-Storage
This is the part that’s not good news. The problems we face in self-storage today fall into three general categories: pricing, old debt/new debt, and the market.
Pricing. Real estate pricing depends on the market capitalization rate (cap rate) at which the income of a property is discounted. The lower the cap rate, the higher the price, which, of course, makes the reverse true as well. Cap rates for the entire commercial real estate market were at long-term historic lows (meaning higher prices) from early 2005 to late 2007.
In addition to cap rates declining dramatically, property appraisals were also increased because higher anticipated rents and occupancies were added into the income, which was capitalized into the value of the property. The traditional cap-rate model for valuation was (and is again) that net operating income (NOI) was based on the trailing 12 months of actual income. Thus, prices were inflated by the lower cap rates and the positive assumption of future rents.
Just to give you a little perspective, in 2006, it would not have been unusual to see a property with a $200,000 NOI and a 10 percent anticipated increase in rent to be valued on a 7 percent cap rate and, therefore, valued at $3.19 million. Today, the cap rate would be in the range of 8.5 to 11.5 percent (more on this later). Just to use a number, let’s assume the cap rate is 9.5 percent and the NOI is actually down 7 percent; the value of the same property is now $1.9 million, a loss of 40 percent.
The same general pricing rules apply to all commercial real estate, except revenue in other types of real estate is down much more than in self-storage. All in all, self-storage pricing is holding up better than other real estate categories. However, this isn’t much consolation to owners who have seen their value and equity decrease. The question is, will cap rates go back down? This is for you to decide, but in the last 60 years, they were never as low as they have been in recent years.
Old debt/new debt. The nice thing about “old debt” was that it was cheap, plentiful and easy to obtain. The problem is it eventually matures and sometimes prohibits a sale of the property until loan maturity, which limits owners’ flexibility. At the height of the commercial mortgage-backed security (CMBS) loans, money was inexpensive―sometimes as low as 4.5 percent to 5 percent―and no loan amount was too much. All it took was a call to just about any bank or mortgage broker. This happy confluence of circumstances caused many owners to over leverage (a polite way to say they borrowed too much) by getting too large of a loan for their property.
Now, many owners are now locked into these loans for the duration of the term and can neither sell nor refinance their property. Unfortunately, given the current situation in the lending world, it’s unlikely that many of loans financed before 2008 could be totally refinanced today. The new lending standards would reflect the new valuation. The loan-to-value ratios have also declined from about 80-plus percent to 65 percent (on a good day), and interest rates have increased about 1.5 percent. Additionally, the amortization periods will likely be shorter, and there aren’t many interest-only loans. The lack of available loans is a serious problem for buyers as well, because in essence, the lenders are setting the maximum price.
The market. Self-storage buyers and sellers are deeply uncertain about the future. Of course, this is not the greatest scenario for agreeing on a price. Sellers don’t want to accept that property values are down because they believe their facility is still performing or will come back quickly. The buyers, who are almost all existing owners these days, think the market may go down further or are thinking they can drive a hard bargain.
In addition, the appraisers are not helping to identify the appropriate market cap rate or value―not because they don’t want to, but because comparable information on past sales is scarce and likely out of date. Information is also sparse because there have been so few deals in any one market over the last six months.
Clearly, all this is a problem not only for buyers and sellers, but for brokers who advise them in these difficult times. Sellers should first understand their reasons for selling. Is it simply fear, or do you have a personal reason (retirement, health, etc.)? Is it that you know your property is in a declining market? Is your debt more than the property is worth? When you answer these questions, you’ll have a better idea of what you should do.
If you make up your mind to sell, you must accept that the value available in the market today will likely set the price, and lenders may be even more difficult than the buyers themselves. This doesn’t mean you must accept the first buyer’s offer, but you should know that qualified buyers are scarce and be willing to negotiate.
The buyers in the current market fit into one of two general categories. They’re either experienced self-storage owners looking for good deals, who have the equity and ability to finance purchases, or they’re “bottom feeders” who make quick, but low offers and may or may not have the ability to close a deal. These buyers, however, may be the only option for some troubled properties.
While the market is slow and inconsistent in pricing, we’re beginning to see some modest convergence in sale prices reflected in a narrower spread of cap rates. The rates (and, hence, prices) are highly dependent on location, market and quality. The actual sales we’re seeing at this time often tend to be in the 9 percent to 10 percent cap-rate range.
I’ve seen sales at an 8 percent cap rate and some as high as 11 percent. You should know cap rates are still volatile and may be trending generally higher, according to some analysts. However, if someone tells you they know the current cap rate, you can bet they don’t know for sure.
Fortunately, self-storage is probably the best kind of real estate to own right now. Given the miserable performance of all other commercial real estate, this is now merely a consolation prize. But for the longer pull, we’re optimistic about our industry. This contraction of this highly speculative real estate market, funded by grossly errant, greedy lenders will bring constrained funding for new projects and allow markets to adjust to new realities.
The performance of self-storage in the worst downturn in the last 80 years has shown the business to be quite adept at competing and remaining profitable in the marketplace. This bodes well for the future of our industry. Ultimately, the real estate side of the business will also reach equilibrium. At least, it always has!
Michael L. McCune is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self-storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE.