When investors and lenders talk about real estate, they often use the phrase “the four main food groups,” referring to the core asset classes: industrial, multi-family, office and retail. All other asset classes are considered secondary, as they have nuances many investors or lenders don’t care to understand. Just as the “food pyramid” has been replaced with the “MyPlate” nutrition guide for a healthy daily diet, it’s time to update the real estate “food groups” to include—you guessed it—self-storage.
Over the last 10 years, no other asset class has performed better, on a risk-adjusted basis, than self-storage. The industry proved resilient through the recession, and since then has achieved record rental rates and occupancy levels, ultimately leading to best-ever net operating income. This resilience combined with stellar operating performance and low ongoing capital costs have forced investors to take notice.
To see evidence of this, simply look at the stock prices of the four largest publicly traded self-storage real estate investment trusts, which are hovering around all-time highs. You could also look at the spike in industry valuations over the last four years. It’s not uncommon for a self-storage facility in a primary market to trade at a sub-5 percent capitalization rate, or for a facility in a secondary market to trade at a sub-6.5 cap rate—both significantly lower than in years past.
On the equity side, fresh capital trying to enter the self-storage market is also at an all-time high, which is part of the reason cap rates are so low. As a way to gain exposure to the asset class, many investors—who lack the operational expertise to manage storage facilities—are looking to partner with existing developers and operators. Many of these relationships take the form of a joint venture.
Joint-venture opportunities can create significant value for who need new sources of capital. When structured correctly, they can draw on the strengths of both parties: a self-storage operator with expertise and a serious need for fresh equity and a well-capitalized partner who has a specific set of investment goals and return expectations but is devoid of operational knowledge. That said, joint ventures can also be complex. Following is a breakdown of joint-venture capital and partnerships as well as what you, as the self-storage developer or owner, need to know.
There are many players providing joint-venture equity today, including:
- Family offices (private wealth-management advisory firms that serve ultra-high-net-worth investors and families)
- Pension funds and pension-fund advisors
- Insurance companies
- Real estate private equity groups
- Hedge funds
These sources typically like to place large pockets of money at one time (in excess of $3 million). To put some context around that number, a self-storage operator or developer would need a $10 million single asset or portfolio levered at 70 percent to gain significant interest from a joint-venture partner. With that said, as the market becomes increasingly competitive, equity sources are considering smaller deals as a way to get their foot in the door, especially if they see a pipeline of business with that operator down the road.
Coming to Terms
When evaluating partners, it’s important to find one that’s trustworthy and has sufficient capital for the opportunity at hand. Early discussions should revolve around hammering out a set investment-horizon period and a fixed level of capital contribution. Other items to address include:
Exit strategy. A clear exit strategy is crucial to the success of the partnership. There should be no blurred lines regarding the expectations and level of commitment required by both parties. In today’s market, a real estate joint venture may have a holding period of two to 10 years, and the initial contribution pledged by the operator, or the “skin in the game,” can be in the range of 1 percent to 20 percent of the contributed equity. For example, suppose the capital needed for the project is $10 million, and it’s agreed that 70 percent of the capital stack is made up of debt, leaving $3 million of equity. In a 90/10 split, the capital partner will contribute $2.7 million and the operating partner will contribute $300,000.
Decision-making. The operating partner is typically in charge of all decisions affecting the property’s daily operation. The capital partner will have significant, if not total, control over capital events (refinance or sell), any change in ownership, approval of an annual budget and significant capital expenditures, as well as the ability to approve or deny investments into new projects.
Fees. Additional considerations include the fees that will be earned by the operating and capital partners, respectively. Examples include acquisition fees (finding the deal), financing fees (who arranged the debt), development fees, construction-management fees, asset-management fees, property-management fees and due-diligence fees, to name a few. This should all be clearly documented in the joint-venture agreement.
While the structural features mentioned above are important, the meat of the partnership is contained in the establishment of the waterfall structure and inherent “promote,” designed to incentivize the operator to boost asset performance. The promote is the return associated with the performance of the asset and begins to lean in favor of the operating partner once base-level thresholds for the preferred equity are surpassed.
Under a conventional waterfall structure, there are several thresholds, or levels, of return distributions. Using the above numbers (and ignoring the compounding of interest), the first tier of returns will pay back the equity partner’s initial $2.7 million and the operating partner’s $300,000. In the next tier, the residual or excess cash will generally be distributed pari passu, or proportionate to, each party’s contribution, up to a certain percentage return threshold. Let’s call it 12 percent.
Assume that after the initial investments have been returned to each party, there’s $1 million in excess cash flow. These proceeds are then split 90/10 percent in favor of the capital partner until both parties have achieved their 12 percent preferred return. With the preferred equity return paid, the next tier may return proceeds 70/30 percent in favor of the equity partner, up to a total of 18 percent. A final tier may return proceeds 60/40 percent in favor of the equity partner of all excess cash flow above the 18 percent threshold. While more complex waterfalls exist, this basic structure demonstrates how a promote can create a high-value incentive for the operating partner to ensure above-average asset performance.
Joint-venture partnerships aren’t right for all self-storage operators. Those who have created successful companies by leveraging the capital of friends and family, or have “country-club equity,” often become frustrated with the oversight and reporting that comes with a joint venture. However, the payoff can be significant for an owner or developer who can leverage his knowledge and limited capital with the vast capital of a partner to acquire or develop significantly more projects he might with other sources.
Devin Huber is a principal at The BSC Group, a Chicago-based commercial real estate financing firm, where he supports self-storage owners nationwide with their lending needs. His expertise and advisory services span all property types, with a specialization in the self-storage asset class. Prior to helping found BSC, Devin was a senior vice president at Beacon Realty Capital and a key member of the firm's Self Storage Group. To reach him, call 312.207.8232; e-mail [email protected]; visit www.thebscgroup.com.