Near the end of 2008, the U.S. Secretary of the Treasury was on his knees begging Congress for Trouble Asset Relief Program money, essentially telling congressional leaders the sky was falling and only the better part of a trillion dollars would cure the problem. Never mind that the money wasn’t spent on what was promised.
In the ensuing months, banks went bust (or should have), loans were impossible to get, home mortgages were being foreclosed left and right, stocks dropped like a rock, and asset values were cut in half or more. Consumers quit spending. CEOs let go of employees by the droves (but not their own bonuses) and, thus, more mortgages went unpaid. In short, everybody was seriously scared and had a right to be.
In the commercial real estate markets, liquidity (i.e., loan availability)completely dried up, causing buyers to disappear and sellers to freeze in place. Goldman Sachs was suggested that cap rates would go up (values down) by 300 to 500 basis points. It looked pretty bleak for commercial real estate, and for several months, transactions were almost nonexistent.
Office buildings cast out their mortgage-broker tenants. Shopping centers lost tenants and renegotiated leases with those that remained. Hotels were hit hard as business and tourist travel came to a near halt. Real estate investment trusts (REITs) discovered they were out of money, and some were forced into bankruptcy. In short, 2009 was a long, slow, scary year.
Why Self-Storage Is Different
A wise man once said, “There must be a pony in here somewhere.” Sure enough, there is a pony, and it’s self-storage. While the industry hasn’t been entirely immune from the effects of the recession, the colossal devastation that has visited other types of real estate has been less damaging for storage properties. This isn’t because of luck; it’s because of natural, positive differences in the way self-storage works as a business.
In the self-storage industry, many follow the REITs quite closely. The U.S. Securities and Exchange Commission requires REITs to publish their audited results on a quarterly basis. Since the self-storage REITs have a broad distribution and large number of stores, this information provides us with a reliable gauge of what the entire market is doing.
When comparing the quarterly results of the REITs for the last year, same-store revenue shows a decline of about 2.7 percent to 3 percent. By order of magnitude, these results are better than those experienced in other real estate categories. While it’s somewhat painful, it certainly isn’t devastating to self-storage operators.
To look at an even more positive aspect of these numbers, let’s run through some math. Let’s say the average self-storage tenant stays a year. If occupancies declined only 10 percent in 2009, then 90 percent of current tenants were new at some point during the year.
This statistic says something very good about the self-storage product and the strong demand and need for it. This isn’t a claim any other real estate class can make about its consistent demand, especially in the worst recession in nearly 80 years.
Every other type of commercial real estate spends huge amounts of money to acquire new tenants. Office-leasing brokers often collect a dollar per year per square foot of space leased, and the landlord pays as much as $25 to $45 per square foot to remodel the space.
Retail, industrial and hotels have their own unique but expensive ways of acquiring tenants. Self-storage seldom requires large capital expenditures of any kind, and rarely does an empty unit require material refurbishing after a tenant moves out. The apartment landlord can only dream of this situation as he repaints, buys appliances or installs carpet between each tenant.
The most important factor contributing to the effectiveness of self-storage is leases are usually 30-day contracts. This allows the owner to adjust rent at any time and react quickly to changes in the market. Increases can be as frequent as the owner wants, and can be relatively small in dollar terms but significant in percentage terms. Apartment leases, on the other hand, usually run 12 months, and other types of real estate lease terms are usually counted in years.
This ultimate flexibility allows self-storage owners to take advantage of lowering rates when demand is low and raising them when demand is high. Many self-storage management firms adjust their “street” rates every day, sometimes more than once a day, and set schedules for each tenant’s future rate increases, sometimes as often as twice a year. The ability to manage revenue is an important and distinctive characteristic of self-storage.
Finally, most self-storage owners have a conservative streak that provides a lot of security in these troubled times. Most have a responsible amount of leverage in their properties. This trait not only protects owners, it collectively helps preserve an orderly market for those that want to sell or buy facilities. Many, if not most, other commercial real estate owners are leveraged to “the hilt.” By way of example, there are a trillion and half dollars worth of commercial mortgage-backed securities loans maturing in the next three years.
To a large measure, these positive fundamentals of our business have saved the day for self-storage owners—so far. First, let’s remember what the first six months of this debacle looked like in terms of the commercial real estate market. The REITs’ stock values plunged because of the projected decline in property value and, more important, their excessive debt and the close maturity of that debt.
Many of the REITs have scrabbled hard to raise equity and refinance maturing loans, but it was at great expense to their shareholders in terms of dilution of share value. The combination of the high leverage on most of the commercial real estate loans and the close maturities make their repayment problematic. The banks―and not just the big ones―simply do not have the capital or risk appetite to make new loans or renew the existing ones. That’s not to say new loans are impossible, but they’re going to be difficult to find and will have dramatically less generous terms.
Current interest rates are in the 6 percent to 8 percent range, with a loan term of 3 to 5 years―on a very good day, maybe 10 years. The underwriting of the loan will be more strenuous, with the value determined by the trailing 12 months of net operating income divided by the cap rate. No pro forma income or excessive “other income” is likely to be counted in the calculation of value. In most cases, the loans will provide for recourse to the borrower, which is a significant change from the CMBS loans they may replace.
Cap rates have also changed during the last year, and new loan proceeds may not be sufficient to retire a maturing loan amount, which might require an owner to put up more equity. Because of low leverage applied by many self-storage owners, this may not impact as many in our industry as other commercial real estate; however, it will be a serious problem for those it does affect.
Cap rates in the beginning of the first quarter of 2009 went up dramatically, and quickly cut the theoretical value of all commercial real estate, including self-storage. Cap rates before the crash were significantly below the rates prevalent in the past 40 years (meaning higher values than in the past). However, because there were virtually no sales occurring, it was difficult to know exactly what the cap rates were in the early months of the downturn.
By looking at comparable sales and listings at the time, it appeared the asking cap rates were roughly 7.5 percent to 8.5 percent, and the offering cap rates were at 10.5 percent to 11 percent. Sellers were saying, “Would I earn a better return just holding my property?” and the buyers were just hopeful bottom fishers. The result was there were not enough sales to accurately define a real cap rate for several months in the first part of 2009.
The cap-rate spreads have now narrowed and are starting to stabilize in the self-storage market. We’re seeing transactions for well-occupied, well-maintained, demographically superior properties at 8 percent to 10.5 percent. There are a limited number of buyers, but inquiries from prospects are increasing to an encouraging level. Most sellers recognize that 2006 and 2007 were years of exuberance in the market, both as to price and ease of sale.
Buyers are equally tamed by their experience over the last several months and are becoming more realistic about pricing. There seems to be more rationality in the self-storage real estate market, and pricing appears to be approaching equilibrium. The demand for self-storage rentals seems to indicate the business is much less fragile than we feared, and the market for buying and selling will be more accommodating in the months to come.
Having made these predictions, here are three cautionary comments: First, if you have a loan maturing in the next year and a half, start planning to replace that loan now if you can. Much of the information in the financial press leads me to be concerned that the smaller banks will be restricted in commercial real estate loans because of their past over aggressive lending and pressure from the FDIC.
Second, now is the time to out-compete your competition by improving your property and marketing. A little money spent now when your competitors are holding back could improve your future competitive situation dramatically.
Finally, be conservative with your cash and watch for signs that the economy doesn’t go in reverse.
Michael L. McCune is president of the Argus Self Storage Sales Network, a national network of real estate brokers who specialize in self-storage. Argus provides brokerage, consulting and marketing services to self-storage buyers and sellers and operates SelfStorage.com, a marketing medium and information resource for facility owners. For more information, call 800.55.STORE.