As self-storage grows into a primary real estate asset class, more deal sponsors and investors are considering it as an addition to their portfolios. Though there are many sources of capital, private equity and debt are two of the most common alternatives to traditional lending from banks and similar creditors. For sponsors, whether you’re alone or part of a team, leveraging these vehicles can help you mature. For investors, they’re a great solution if you’re looking to participate in a deal without having to operate the business. Let’s see how they work, plus some of the risks and rewards.
How They Work
Capital for self-storage investments can be raised from multiple sources including individuals, fund managers, registered-investment advisors, syndicators, Wall Street, etc. This article will focus on equity and debt sourced from private investors, sometimes referred to as retail investors.
You know what they say … No risk, no reward. Private equity is invested in a self-storage project in an unsecured position, meaning it isn’t collateralized by the property itself and is completely at risk. That said, this type of investment is also generally associated with high returns. It usually has a three- to five-year timeline.
Private debt is just like getting a loan from the bank. It usually includes a fixed period, interest rate and monthly payment. Multiple investors are secured in a fractionalized deed of trust with a first-position lien. The returns here are much lower than that of private-equity investments due to the lower risk, with timelines ranging from months to a couple of years. As far as minimum dollars go, there are sites that allow for investments as low as hundreds of dollars; but for most sponsors, the minimum is $50,000.
From the Sponsor Perspective
From a deal sponsor’s point of view, there are three key things to consider when using private equity or debt for self-storage. Usually, the terms are more flexible than institutional capital, which allows for more creativity in deal structuring. Second, retail investors are usually much faster in making decisions, which allows sponsors to be more competitive in the marketplace. Lastly, both private equity and debt are going to be more expensive than institutional capital from a return and interest-rate perspective.
Sponsors need to balance their need for flexibility and speed with the cost of capital. If you have a lot of time and personal resources, using institutional capital may be more advantageous from a cost perspective. If you need speed and flexibility, a retail network of investors is going to be better.
One of the potential drawbacks to using private equity and debt is the reporting requirements. While most private investors don’t impose these on sponsors, it’s the duty of the sponsor to communicate about their investments. Monthly is the gold standard, but quarterly is the minimum if you want to have repeat investors.
From the Investor Perspective
If you’re an investor, participating in equity and debt positions as a limited member can be a great way to grow your wealth. For those with a large appetite for risk and longer timelines, investing in equity with a great sponsor is going to produce the returns you’re looking for—usually in the mid-teens, but sometimes exceeding 20% annually for opportunistic deals.
There are two potential drawbacks to investing in equity positions. The first is 100% of your money is at risk and, depending on the deal, the cash flow during the investment period could be low because of value-add improvements. Due to potential tax implications surrounding unrelated business income tax and unrelated debt-finance income, cash is usually best for equity investments, though most sponsors will allow for the use of a self-directed IRA or solo 401(k) as vehicles.
For private investors who are more risk-averse, investing in private-debt placements can be a great way to earn returns in the 8% to 11% range with relatively low risk. The risk is reduced because most sponsors will put together a factualized deed of trust with a first-position lien on the property as collateral. This allows investors to foreclose on the property if the monthly payments stop.
If you’re a sponsor, private equity and debt can help you grow your self-storage portfolio; but unless you’re independently wealthy, you’ll likely need to leverage both. If you’re an investor looking for something other than vanilla market funds, investing in private equity and debt can be a great way to bolster your efforts.
Private equity has higher returns, but it’s usually unsecured and, therefore, riskier. Private debt is secured, but the returns are lower. Both offer great flexibility but are more expensive than their institutional counterparts.
Remember, whether you’re a sponsor looking to grow your portfolio or an investor who wants to get into the self-storage business, having good tax and legal teams is a must, as there are many nuances to understand and navigate.
Ryan Gibson is chief investment officer and co-founder of Spartan Investment Group, a real estate company that specializes in self-storage investments. He’s responsible for investor relations and capital raises, and has organized more than $125 million of private equity. To reach him, call 202.696.5112 or email [email protected].