Lessons Learned: Riding the Wave

Mini-Storage Messenger – May 15, 2016

As we roll into the spring and summer months, the self-storage sector is enjoying a rising tide of market factors all working to the benefit of owners. Like surfers who dream of waking up to perfect ocean conditions every day, the storage industry is currently riding a seemingly continual wave of rising real estate values and prices.

But why is this tide rising and can we expect today’s “surf’s up” sales/refinancing wave to continue? That depends primarily on four components:

1. Positive Net Operating Income (NOI) Results

2. Higher Valuations Caused by Decreasing Cap Rates

3. Today’s Historically Low Interest Rate Environment

4. Limited New Facility Competition

Positive Net Operating Income (NOI) Results

Industry REIT results from 2014’s fourth quarter continued to support strong industry fundamentals with reported near-optimal occupancy levels ranging from 89.4% to 93%. In addition, NOI year-over-year quarterly results showed impressive 6.8% to 9.5% gains.

Clearly, our industry’s largest players are performing at, or near, peak levels. They also enjoy economies of scale benefits which support state-of-the-art tools and data to help maximize their occupancy and rental rate performance. This elite group of operators reported rental rates per occupied square foot in the range of $11.72 to $15.20, recognizing the top national MSA target markets in which REITs typically operate. Further, their stock prices reflect market admiration for the storage sector as investors increasingly appreciate self storage’s unique operating attributes and relative stability compared to other commercial real estate asset classes.

NOI is comprised of gross revenues less operating expenses, so any owner’s focus must always be on increasing revenues while maintaining expenses. While the REITs and larger operators prove their operational expertise through consistent quarterly results, you can evaluate your operating results against theirs to benchmark operational performance.

Technology advancements, revenue management tools, and the omnipresence of web and mobile devices can help drive revenues and NOI at your locations. They are particularly relevant if you compete against REITs and larger portfolio operators in top MSAs and, to some extent, in certain secondary markets. While the industrywide tide is definitely rising, smaller operators must swim hard and fast to catch the best waves in order to compete with larger owners and REITs at their higher operating and marketing levels.

In addition, we are once again seeing new facilities with all the bells and whistles spouting up in many markets. Due to competitive market and financing constraints, a significant portion of new construction projects are only being built by experienced operators in major markets.

Another way smaller operators are catching the wave to boost NOI and competitive positioning is through using third-party management resources, as well as participating in newly formed owner alliances. Store Local is an example of such an alliance in which owners ban together to share leading-edge operational methodologies, including customer lead aggregation and revenue management tools which can improve their individual ability to obtain highly competitive financing packages.

Higher Valuations Caused by Decreasing Cap Rates

Cap rate compression is partially derived from market supply and demand. Since the start of the economic recovery, institutional and individual investor interest in the self-storage sector has grown significantly. Decreasing cap rates have gotten to the point where it is now common to see major MSA properties being appraised in the 6’s or lower, and which actually trade well below the 6% cap level. From a financing standpoint, lower cap rates have been instrumental in owners’ abilities to increase leverage and, in many cases, extract significant equity from properties.

Many investors look at properties with the idea that if they make some facility improvements, they can achieve an investment return to operating results in a 6-18 month period and thus create an accordingly appropriate price. These assumptions are bringing down purchase cap rates because oftentimes the buyer is looking at a 7%+ cap rate based on projected results in a fairly short timeframe. In fact, some investment brokers are distributing property sale brochures without list prices and letting today’s competitive buyer’s market derive the value.

According to Jeffrey Shouse, director of the Self Storage Valuation Group at Colliers International, there were approximately 1,250 self-storage property listings in 2014, or roughly 5% of total market supply…a surprisingly low number given the extraordinarily strong property valuations. You’d think that today’s aggressive pricing would entice more owners to cash in their chips. Yet if they do, they face a quandary of where to redeploy the sales proceeds and reap equal returns.

Historically Low Interest Rate Environment

Cap rates are also directly derived from the cost of capital, which for variable and fixed rate financing is at all-time historical lows. The global economy is fueling an environment where the 10-year Treasury is hovering around 2% and short-term interest rates remain near 0%. With improving employment levels and a recovering national economy, the Fed has indicated it may increase discount rates as early as June. Any rate changes will impact short-term lending rates, while longer-term rate movement is more uncertain.

Contributing further to all-time low fixed-rate financing levels, CMBS lenders are quoting tighter spreads over indices (the 10-year Treasury swap rate). Across the board, we are seeing a loosening of credit and underwriting standards. The storage industry’s major lending sources are all stretching from where they were even three to six months ago, thus leading to a borrower’s market. Our experience shows that a lender’s terms and ability to deliver financing vary widely, therefore shopping for interest rates is just one component you should evaluate when pursuing financing.

Limited New Competition

According to F.W Dodge, peak construction activity occurred in 2005 when 3,665 storage units came on the market. With rising facility prices and valuations, more investors are pursuing the development route than buying existing properties. However, it does not appear we will get anywhere close to the development heights we saw in the mid-2000s for three primary reasons:

1. Conservative lending committees whose construction financing is only for select, experienced operators

2. Securing compelling sites and obtaining entitlements is now more difficult, costly and time consuming for developers

3. Project costs can be prohibitive

At the Self Storage Association Economic Summit this past March, Dave Bragg, managing director at Green Street Advisors, predicted that approximately 300 new storage facilities will open in 2015, 600 in 2016, and 900 in 2017. Given recent construction activity by large operators, his estimates may be on the low end.

Surf’s Up

Regardless of your operating size, you should enjoy our industry’s rising market tides. But before you hit the lending ocean to surf your financial options, consider an old expression: “PAPA,” which stands for Pay Attention, Plan Ahead.

Like ocean currents, market dynamics continually change. If you are poised to refinance, definitely explore your options. You may also want to reevaluate your investment objectives and determine if selling your property makes better sense than refinancing. Be sure to stay apprised of new competition coming to your markets and prepare yourself to take on this new supply, not to mention traditional competitors who are undoubtedly positioning themselves to catch that growing wave of storage customer demand before you do.

With more than 22 years of experience as a national self-storage mortgage broker and advisor, Neal Gussis is a Principal at CCM Commercial Mortgage, where he specializes in securing debt and equity for self-storage owners nationwide. During the past 12 months, CCM has secured more than $180 million in customer financing. Based in Chicago, he can be reached at 224-938-9419 or ngussis@CCMCommercialMortgage.com.