In today’s self-storage investment market, a primary concern is a potential significant uptick in inflation. Over the past 10 years, the average rate of inflation in the United States has been about 1.8%, however, many experts are now predicting more due to the impact of the pandemic stimulus bill, low interest rates and a rapidly recovering economy that’s flooding the market with cheap money. The result will be increased competition for goods and services resulting in rapidly rising costs.
The common way to protect a self-storage investment is to increase revenue along with the inflationary rate while keeping expenses the same. At first glance, this might seem impossible, but wait … Is self-storage inflation-proof? Perhaps we’re in good shape in our modest corner of the real estate business.
Let’s spend a few minutes exploring self-storage as a hedge against inflation. We’ll also look at the positives and negatives to see how this asset class stacks up against other real estate.
A Stable Product
The self-storage business model of short-term, month-to-month leases and a fixed-base expense model is setting up investors and owners in this business to outperform those of other commercial sectors. We’ve learned that the ability to raise or reduce rents quickly allows facility operators to outperform the market.
Regular rent increases on the existing tenant base don’t cause tenants to move out. Moreover, the dollar amount of an increase, while small in total dollars ($10 to $50), results in a large jump in revenue. Not to mention, the highly granular base of 200 to 900 tenants per property on average means the impact of price-sensitive customers who do move out isn’t significant to the bottom line.
The Value Factor
We’ve all heard about rapidly rising steel costs and a surge in overall construction costs. This is a direct result of inflation. In turn, we’re seeing self-storage buyers put more emphasis on the price per square foot and less on the income approach when valuing a property. Most buyers are using a blend of cost basis and income approach to arrive at a value. In the short term, inflation will drive up values for hard assets like self-storage properties.
However, rents will lag. Even with the best revenue-management system, there comes a point when customers simply can’t afford to pay more. Thus, self-storage facility valuations will be based more on replacement cost than actual returns. This will lead to compressing yields. Only time will tell whether the investment community feels self-storage is still a good risk-adjusted opportunity. So far it has been the shining star.
Controlling expenses is another matter, but self-storage starts with a great advantage over many other real estate types because the gross margins—say 60% to 65%—are better, with expenses equaling roughly one third of revenue. As a result, profit margins are higher and there are fewer expenses per dollar of income.
When you look at the nature of self-storage expenses, you’ll find additional benefits. First, energy use, which has been a high inflation producer in recent history, is well below the average of most businesses. Second, real estate tax, which is typically the largest expense, has only a rough correlation to inflation and may not automatically react. Third, our labor is usually not as highly paid as workers under union contracts and in highly skilled professions that are closely linked to inflation. While it’s hard to precisely quantify these distinctions, they’re real and tend to mitigate the impact of inflation on self-storage investments.
Other Real Estate
What about using other real estate as an inflation hedge? The results are less dramatic because office buildings, industrial and retail often have long-term leases that inadequately compensate for cost increases. A little inflation that isn’t compensated for in the lease over a 10- or 15-year period will compound into a healthy diminution in the value of the cash flow. For example, a 5% increase that’s left uncompensated in a 10-year lease will decrease the worth of the cash flow and value by 40%. This doesn’t even include the improvements and leasing commissions you’re required to offer tenants in these other asset classes.
All in all, while not perfect at stopping inflationary pressures, self-storage certainly seems better positioned than most commercial real estate as we head into uncertain times. As the pandemic fades and people start spending money they’ve saved and invested over the last year, the velocity of currency in the market will likely increase. If this happens, inflation and higher interest rates could become a reality.
Reprinted with permission from List Self Storage.
Ben Vestal is president of the Argus Self Storage Advisors, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to buyers and sellers via an extensive marketing platform. Property listings and informational resources can be found at the company website. For more information, call 800.55.STORE; email [email protected].