The self-storage industry is getting unprecedented attention as investors perceive the sector to be a “safe haven” for their money. The culmination of extremely favorable capital markets, low interest rates and robust key performance indicators is drawing capital to the market. Thanks to high occupancies and strong rental-rate growth, people are rushing to find entry points into our industry.

Of course, nothing remains static. Changes occur every day, particularly with regard to the equities market, which translates to potentially even more capital attracted to self-storage. As they flee from more volatile sectors, investors seek stability when deploying capital, and this industry has certainly demonstrated strength in periods of duress.

Drafting behind some of the most unusual times in the history of money, the U.S. economy continues to morph into an ever-changing pot of opportunity and stressed capital. COVID-19 nearly destroyed some real estate sectors like hospitality, retail, office and others, and the phoenix rising from the ashes appears to be self-storage. Our industry’s ability to resist wild fluctuations during economic turbulence is extremely attractive to investors.

With the potential for two consecutive quarters of negative growth in the U.S. gross domestic product—meeting the technical definition of a recession—investors will continue to seek safe investments or stockpile cash in an effort to create large, dry-powder reserves for more opportunistic transactions. The question for those who ultimately choose self-storage is whether it’s better to buy an existing facility or build a new one.

Buy or Build, Which Is Best?

The answer as to whether it’s better to buy or build may be different for every self-storage investor. The key is to find the risk-reward balance to determine how speculative or conservative your capital is. For example, generational wealth can tolerate more risk when the war chest is large and losses are easily absorbed. This is often the case with large family offices. The opposite is a syndication with few investors (each having much more capital at risk) in which failure to meet returns is devastating.

Another major factor is timing and the ability to sustain periods in which there’s only outflow (no return), such as with a new development. This risk is exacerbated by “time over target,” meaning the long incubation periods when a self-storage project is attempting to reach stabilization expose the investment to other potential perils, such as changes in economic conditions and unforeseen events.

Building Self-Storage

From a return perspective, new self-storage construction will almost always outperform a facility acquisition (assuming the project is well-conceived). This is the confluence of created value (dirt to cash) and risk. If you follow the timeline of a typical development, it’s easy to see that it takes very patient capital to realize full value. What could possibly go wrong in 71 months? Yes, that’s almost six years!

During any stage of a self-storage development, there might be recession, pandemic, war, $6 gas prices, hyper-inflation, 10% unemployment and so on. Other potential impacts include failure to obtain approvals, local municipal politics, changing building codes, rising steel costs, oil embargos that drive up shipping costs, new competitors, plant closings and other localized economic matters. The list goes on and on.

On the positive side, capitalization (cap) rate compression, increased barriers to entry, new plant openings and myriad other positive events can drive investment returns to unprecedented levels. This creates value as the gas in the engine that drives profit.

Pursuing a self-storage building project also allows the developer and investor to put their own signature on a site as well as to design and build to specific brand standards. The ability to create your own unit mix, product type, amenities and scale increases value and, thus, higher returns. First-in-market developments may also deter potential competitors or at least elevate the barriers to entry.

In addition, the accretive value from lower real estate tax valuations and increasing self-storage rental rates fuels the fires of investment returns. Using current construction materials can reduce operating expenses, and the age of the improvements allows for decreased operating expenses, reserves and maintenance costs.

Buying Self-Storage

The absolute beauty of a self-storage acquisition is the immediacy and certainty of cash flow, which makes the buy scenario very attractive. A proven performer with a track record of high occupancy and rising rental rates may be the formula to ensure that not only is projected cash flow attainable, it’s sustainable.

The risk factor in a self-storage purchase is seemingly very low, and proper due diligence will confirm the veracity of the reported cash flow. One must then look at cash-flow/return disruptors of which there are a few. The primary risk may be new competitors building in the area that have the potential to out-position the acquired asset. This could occur via a location advantage or a product better matched to the market.

When considering a self-storage acquisition, look at where the competitive development possibilities exist. Look for vacant sites as well as buildings and businesses in transition. This includes industrywide corrections like roller rinks, bowling alleys and drive-in theaters. Each of these are potential self-storage development opportunities, which can threaten the stabilized and growing cash flow of an existing facility.

Not only could these potential sites affect supply, in typical lease-up scenarios, rates are slashed to gain physical occupancy. It takes time to push self-storage rents back to stabilized projections levels. Isn’t it interesting that a building project poses a potential threat to a buying scenario, but an acquisition is more than likely to drive better rates in a market, thus benefiting a new development?

Acquisitions often provide opportunities to increase rental rates, particularly when purchasing a mature self-storage site that hasn’t benefited from revenue management or whose market position is stale because current management hasn’t pushed it forward. The ability to examine historical cash flow and market conditions can assure an investor that revenue is sustainable or, even better, can be improved.

You might be cautious when acquiring institutionally managed self-storage properties, however. Consider that some real estate investment trusts invest millions of dollars in sophisticated revenue-management tools. Their ability to use big data to determine rent trends and consumer behavior is a significant advantage not afforded by most independent operators or small to mid-sized management companies.

Weighing Options

Self-storage acquisition vs. development is a little like the story of the tortoise and the hare. The development project is a long, slow journey, while acquisition provides immediate returns. Development takes longer to produce stabilized, sustainable cash flow, and the projections (pro forma) are quite risky.

It’s worth considering whether historical self-storage metrics predict the future. Let’s look at an example using cap rates from four years ago (5%), today (3.75%) and a presumptive lower cap rate (2.5%) from sometime in the future, with all other property metrics being equal.

What’s the likelihood that cap-rate compression will continue at the same rate in the next three years? It isn’t uncommon to find a 3.75% cap rate today for a class-A self-storage property with institutional cash flow, which is down from 5% in 2019. The above table assumes the market can replicate itself in three years with another 1.5% drop. But how likely is it that the trend will continue? Could the rise in interest rates factor into the ability for the market to achieve 2.5% cap rates? What other sectors trade at that rate?

Another issue is negative leverage. If interest rates are 4.81% (75% conduit loan as of June 1) and cap rates on self-storage are 3.75%, that’s a negative spread of 106 basis points. Quite frankly, the only way those transactions make sense is if there’s significant rental-rate growth. It could also work if this is a value-add project in which physical occupancy is at 90% and the rates are moving to market (discounts and concessions eliminated by revenue-management tools due to high occupancy and strong demand).

The latter builds a pretty strong case for development if the investor is chasing yields and risk-tolerant. My mentor, Ken Woolley, once said that the real money in self-storage is made in the acquisition, not ownership. What he meant is that one must buy the asset at the right price, so you don’t pay out all the upside to the seller.

So, what about development value? In the accompanying cap-rate table, a reasonable forecast to get to $1 million in annual self-storage rent is a project with 75,000 net rentable square feet, which only requires rent at $13.33 per square foot (assuming 25% is climate-controlled, with the remainder drive-up space). As the old saying goes, you do the math by looking at a comparison of five-year holds.

Based on the table, is it better to buy or build this project? Depending on your risk-reward tolerance, your answer may be different. You make the call!

RK Kliebenstein is principal of Coast-to-Coast Realty Advisors LLC. He has more than 35 years of self-storage industry experience. He’s currently developing five projects as well as placing $25 million of equity in acquisitions. He’s also a consultant and offers turnkey self-storage investing on behalf of clients. To reach him, email [email protected]; visit https://askrk.com.