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Cracking the Code: Finance and Real Estate Terms Every Self-Storage Investor Should Know
As you travel your self-storage investment journey, you’ll no doubt encounter some unfamiliar lingo. Understanding what each term means and how it relates to your transactions is key. Learn some common and advanced verbiage related to finance and investing, plus phrases you’ll hear if you plan to participate in syndications.
10 Min Read
Successfully navigating the world of self-storage investing requires a solid comprehension of the terminology used, so you can communicate properly and fully understand any opportunities that arise. This article aims to define the most common and important terms used in finance and real estate, plus phrases you’ll need to know if you plan to participate in syndications.
Please note: I’m a self-storage developer and investor, not an attorney or financial advisor. Before making any decisions regarding your investment plans, it’s best to consult with an expert.
Common Self-Storage Investing Terms
It’s typical to see and use the following terms in most self-storage real estate deals. Let’s begin with two very basic phrases you likely already know.
Operating expenses. These are the costs associated with running and maintaining a self-storage property, excluding debt service (loan payments and interest) and capital expenditures. They include things like utilities, maintenance, payroll, property-management fees and insurance.
Net operating income (NOI) is the revenue generated by a property after operating expenses are deducted but before debt service and taxes. It's a key indicator of a facility’s financial performance and is often used as part of determining market value.
The following additional terms are presented in alphabetical order, though you may encounter them differently in the course of your travels.
Capitalization (cap) rate. Used to estimate the potential return on investment (ROI) of a self-storage asset, this is calculated by dividing the property’s NOI by its current potential market value (what a buyer is willing to pay for). For example, an NOI of $210,000 and an asking price of $3 million result in a 7% cap rate.
Cash-on-cash return. This is the measure of a property’s annual pre-tax cash flow relative to the total cash invested. It provides insight to the asset’s cash-generating ability. This simple metric tells self-storage investors how much money their investment will generate as a percentage.
Debt-service coverage ratio (DSCR). This measures a property's ability to cover its debt obligations. It's calculated by dividing NOI by total debt service. An NOI of $150,000 with $90,000 of total debt service results in a DSCR of 1.67.
Due diligence. This is the comprehensive analysis of a self-storage asset’s overall condition to assess risks and opportunities. The process includes physical inspections, financial audits, environmental assessments and market analysis.
Equity multiple. This indicates how much an investor's capital will grow over the investment period. The most simplistic of all the return metrics, it's calculated by dividing the total cash distributions by the total equity invested. If an investor puts in $100,000 and receives $200,000 back, that’s a 2X equity multiple.
Exit strategy. This outlines how and when investors will realize their returns on a self-storage investment, typically through sale or refinance.
Gross potential rent. This is the total rental income a self-storage facility could generate if fully leased at market rates, without accounting for vacancies or concessions.
Hold period. This is the expected amount of time that a self-storage facility will be owned before being sold or refinanced. Also known as the investment lifespan, it impacts projected returns and investment strategy.
Leverage. This refers to the practice of using borrowed capital (i.e., debt) to increase the potential return of a self-storage investment. While it can amplify gains, it also increases risk. Lower leverage results in less risk but reduces return.
Pro forma. This financial projection estimates an investment’s future income, expenses and cash flow to help you evaluate potential profitability.
Refinancing. Replacing an existing loan with a new one, often to secure better terms or extract equity from the business. This is one exit strategy, as it can allow for capital (equity) to be returned to the investors.
More Advanced Self-Storage Investing Terms
Following are more advanced terms with which you should be familiar, particularly when participating in self-storage investments with partners or a group.
Capital stack. This represents the hierarchy of financing sources used to fund a real estate investment, comprised of debt and equity. Each layer of the stack has different risk and return profiles.
Equity. This is capital contributed to an investment property by the investors. Common equity is high risk but also high return. Preferred equity takes precedence in the event of a sale.
Debt. This is financing used to fund a real estate deal. It can come in different forms such as senior debt (the primary mortgage or loan) and mezzanine debt (which fills the gap between debt and equity). Debt must be repaid with interest within a set time period.
Sponsor. In real estate, the sponsor is the person or company responsible for the investment. They find, acquire and manage the property. When the time comes, they sell or refinance it. They’re also responsible for communicating with investors, and distributing payments and tax documents.
Limited partners. These are passive investors who contribute capital to the investment but have limited liability and decision-making power. They share in the profit according to their investment percentage but aren’t involved in day-to-day management.
Sponsor promote. This is the sponsor's share of profit after limited partners receive their preferred return of capital. It's an incentive for the sponsor to maximize the investment's performance.
Internal rate of return. This metric evaluates the profitability of a self-storage investment over time. It represents the annualized rate of return that makes the net-present value of all cash flow equal to zero. This is a nuanced number, as it values ROI respective to time, with it being worth more today than later.
Preferred return. This is the threshold return limited partners receive before the sponsor shares in the profit of a self-storage investment. It prioritizes investor returns and aligns everyone’s interests.
Waterfall structure. This outlines how and when money is distributed among partners. It specifies the order and conditions under which cash flow is allocated, often after meeting the preferred return and return of capital. For instance, at the start of the investment, the profit split may be established at 60% to the limited partners and 40% to the sponsors. Once a certain level of return has been achieved to the limited partners, the split reverses. Usually, waterfalls are used to allow sponsors to partake in more of the upside if the asset exceeds initial projections.
Capital call. This occurs when the sponsor requests additional funds beyond the initial investment, often to cover unforeseen expenses or take advantage of new opportunities. Investors will be required to provide additional capital in proportion to their ownership percentage, otherwise that percentage can be proportionally reduced.
Depreciation. This tax strategy allows investors to deduct the cost of the self-storage property over its useful life, reducing taxable income and enhancing after-tax returns.
Cost segregation. This tax strategy that accelerates depreciation deductions by reclassifying site components into shorter depreciation periods.
The Language of Real Estate Syndications
At its core, a syndication is a partnership between investors to collectively finance and manage a property or portfolio. It combines the expertise of a sponsor with the capital of multiple investors to acquire and operate real estate assets. The entity is governed by an operating agreement and the private placement memorandum (both defined below). There are infinite ways it can be structured when it comes to sharing classes, ownership splits, return profiles, loan terms, etc.
If you’re interested in participating in a self-storage syndication, below are the key terms you need to know, organized by category.
Self-Storage Syndication Terms: People
Sponsor. Also known as the syndicator or general partner, this is the individual or company responsible for organizing the syndication. They handle everything from finding and acquiring the self-storage property to managing operations and executing the business plan. In return, they receive a portion of the profit and various fees. The sponsor is the active party in a syndication while limited partners are passive.
Limited partners. These are passive investors who contribute capital to the syndication but have limited liability and decision-making power. They share in the profit according to their investment percentage and the structure of the syndication but aren’t involved in day-to-day management.
Accredited investors. These people meet certain income or net-worth criteria established by the Securities and Exchange Commission (SEC), which regulates the U.S. securities markets. The individual conditions to achieve accredited-investor status are subject to change. At the time of this writing, they included:
A net worth exceeding $1 million, either individually or jointly with a spouse
An annual income exceeding $200,000 individually or $300,000 for joint income for the last two years
This status allows accredited investors to participate in unregistered securities offerings, including many real estate syndications.
Self-Storage Syndication Terms: Documents
Subscription agreement. This legal document acts as the mechanism of investment. It outlines the terms under which a self-storage investor purchases shares in the syndication. By signing it, they commit capital to the project and agree to the conditions specified.
Private-placement memorandum (PPM). This legal document provides detailed information about the investment opportunity, including risks, terms and conditions. It’s essential for compliance with securities regulations and helps investors make informed decisions. It’s crucial that sponsors encourage their limited partners to thoroughly read the PPM, as it helps manage expectations and ensure full understanding of the investment.
Operating agreement (OA). This document details the governance of the syndication entity including roles, responsibilities, voting rights and profit distribution among partners. As with the PPM, it’s critical that sponsors encourage their limited partners to thoroughly read the OA to manage expectations and ensure full understanding of the investment. The subscription agreement, PPM and OA form the full syndication structure.
K-1 statement. This is a tax document provided to each investor, detailing their share of the syndication's income, deductions and credits for tax reporting.
Self-Storage Syndication Terms: Fees
Acquisition fee. This is paid to the sponsor for their efforts in sourcing and closing the self-storage deal. It usually ranges from 1% to 3% of the purchase price. This helps offset some of the sponsor’s costs such as marketing.
Asset-management fee. This ongoing fee compensates the sponsor or third-party management company for managing the self-storage facility post-acquisition. It's typically a percentage of collected revenue or assets under management. This fee helps offset the operating costs such as staff payroll.
Disposition fee. This compensates the sponsor for managing the sale of the self-storage property. It incentivizes them to maximize the price.
Self-Storage Syndication Terms: Principles
Blue Sky Laws. These state securities regulations aim to protect investors from fraudulent practices. Compliance is necessary when offering securities, such as a piece of a self-storage investment. When setting up a syndication, sponsors should anticipate this as an additional cost. There’ll be additional filing fees when limited partners live in several states.
Regulation (Reg) D exemptions. These allow companies to raise capital without registering securities with the SEC, subject to certain conditions and limitations. For real estate syndications, the exemptions usually fall into two categories: Reg D 506(b) and Reg D 506(c). The 506(b) is open to non-accredited and accredited investors with whom the sponsor has a pre-existing relationship but can’t be publicly marketed (think “b” for “buddies”), while 506(c) is open to accredited investors only but can be publicly marketed (think “c” for “commoners”).
The Lexis of Success
An understanding of these key terms is essential for anyone who wants to participate in self-storage investing. Clear communication and a solid grasp of industry vocabulary foster stronger partnerships and more successful transactions. Whether you're a passive investor looking to diversify your portfolio or an aspiring sponsor looking to structure your first deal, this knowledge will empower you to navigate the complex world of real estate with confidence.
Remember, every self-storage investment carries risk, and it's crucial to consult with financial and legal professionals before committing capital. Armed with the above lexicon, you'll be better equipped to ask the right questions and make informed decisions that align with your investment goals.
Steven Wear is co-owner and chief marketing officer of Chicago-based Self Storage Syndicated Equities, which provides access to tax-advantaged self-storage investments, with an emphasis on wealth growth and social stewardship. Under his guidance, the company has acquired dozens of self-storage facilities nationwide at an average of 28% discount to market value. To reach him, call 847.666.8885 or email [email protected].
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