At first glance, it may appear as though the self-storage real estate investment trusts (REITs) are acquiring every property on the market. However, this is hardly the reality.
In this article, I’ll dispel some of the anxiety surrounding industry consolidation and discuss the related challenges and implications. I’ll also look at future trends while taking a big-picture view of what’s happening with self-storage ownership as we approach the next decade. Despite the belief that industry consolidation is occurring rapidly, the data demonstrates otherwise.
REITs account for just 13.4 percent of the 41,879 facilities in the nation, according to the “2017 Self-Storage Almanac,” an annual publication of industry data. With the remaining top 100 owners/operators accounting for another 10.8 percent, this leaves 76 percent of storage properties held by smaller regional and local owners.
Many of these owners might believe the best option for a sale would be to allow a REIT to acquire their property. However, the REITs are very selective in the assets they choose. Their strict set of requisites opens the door for competition from larger institutional groups and regional owners who are willing to pay competitive prices for assets that don’t necessarily fit the REIT criteria.
The REITs typically look for assets with 50,000 to 80,000 rentable square feet, in densely populated areas in larger metropolitan markets. Although there are many institutional and regional investors that will acquire assets in an urbanized area—defined as one with a minimum population of 50,000—the U.S. Census Bureau indicates there are fewer than 500 of these markets in the U.S.; and many won’t yield the density the REITs require.
In addition, most REITs seek ideal assets that meet other requirements. For instance, facilities that include retail or mixed-use components, or ancillary income from ancillary services such as a car wash, may fall short of the criteria. However, other investment groups might be willing to pay for those assets to build their portfolio. With these varying acquisition requirements, most facilities don’t fit within the REIT standards.
Beyond this, REITs are looking for economies of scale, providing management efficiencies and abilities that allow the subject property to be competitive with advertising and strong search engine optimization (SEO). While they have large market shares in many of the nation’s top Metropolitan Statistical Areas, outside of these markets, they can’t operate as effectively. Simply put, there are many communities in which a local owner or smaller regional operator is more competitive than a REIT. Because of this, there will always be room for a multitude of investors and owners in the industry.
Last year, several large-scale REIT acquisitions took place. One of the largest deals of the year was Sovran Self Storage Inc.’s purchase of LifeStorage LP’s 84 properties in nine states for more than $1.3 billion. National Storage Affiliates Trust (NSAT) was also aggressive over the past year, acquiring 22 California properties for $154 million. It also bought the iStorage portfolio for $630 million, adding 66 properties across 12 states and 24 markets, and another 26-property portfolio for $184 million.
Despite 2016’s big sales, my team has observed a slowdown this year in large acquisitions from the REITs. With these companies projecting slowed revenue growth due to increased supply as well as a ceiling on market rents in some urban areas, there’s been a decrease in their trading value. This loss of value has impacted their ability to pay what owners are expecting for assets, slowing the acquisition pipeline.
We’ve also seen a slowdown in the sector’s quarterly transaction volume. The third quarter of 2016 was at a peak of about $2 billion in sales, while the fourth quarter was at $1.8 billion. Meanwhile, the first quarter of 2017 slowed to $727 million, down 25 percent year-over-year, according to Real Capital Analytics, a firm that provides data on the commercial real estate investment markets.
On the development side, only a small portion of the proposed, in progress or newly completed projects are anticipated to originate from the REITs. Specifically, of the 387 recent self-storage completions nationwide, only 5.7 percent have shown to be backed by REITs.
Presently, my team is tracking more than 1,400 properties in the development pipeline, whether in the planning stages or under construction. Of those, approximately 6 percent are slated to be REIT properties. This data clearly demonstrates that developers and regional owners are building new properties at a rate that’s outpacing the REITs’ abilities to acquire new properties.
Taxes and Technology
As new competition enters the market and rental-rate growth flattens or declines in some areas, investors will be looking for alternative ways to increase their net operating income (NOI). With real estate taxes and payroll typically being the two largest expenses for self-storage owners, ideas to reduce those costs can be intriguing, with the latter (staff cuts) being a more viable option. Taxes will also be an ongoing concern, as municipalities are reacting to rising facility valuations and beginning to assess accordingly.
The concept of automated self-storage facilities has been around for quite some time, but recent advancements in technology are causing many owners to take the idea more seriously. Many businesses are looking at kiosks to replace employees (i.e., McDonald’s with its automated food dispensers), and self-storage is no different. Onsite management typically accounts for 20 percent of overall expenses at a storage facility, and drastically reducing that figure can have a dramatic effect on NOI.
Nonetheless, the extent to which an automation approach will affect property values is yet to be determined. Buyers typically underwrite to their average expense ratios, and most haven’t delved into the automated world just yet. But as more facilities become fully mechanized, buyers will be forced to underwrite appropriately or lose out on the opportunity.
Looking ahead, the new supply hitting the self-storage landscape is projected to stagger, putting downward pressure on rental-rate growth as markets look to absorb product. This will adversely affect property values and cause buyers to be more cautious with their projections. However, as the industry becomes more mainstream and institutional money pours into the sector, we’ll continue to see solid pricing metrics and demand from investors, resulting in competitive capitalization rates.
While REITs will continue to acquire portfolios, the high competition from private equity and institutional-level investors will make their attempt more difficult. We’ll likely see their third-party management rosters grow as institutional and larger owners take advantage of their advanced marketing platforms, SEO expertise and revenue-management abilities.
At a first glance, the REITs may seem to be consolidating the self-storage market. However, there are many other investors on the scene that will make this a challenge. The storage industry will continue to be a strong sector that persists in moving ahead.
Michael A. Mele is the senior managing director of investments for Marcus & Millichap, senior director of the company’s National Self Storage Group and founder of The Mele Group. He has closed more than 300 self-storage transactions totaling more than $1.5 billion in sales volume. For more information, call 813.387.4790; visit www.marcusmillichap.com.