Equity Based Services, Inc

by Troy Downing

If you build it, they will come. In the heady, cash flowing, free lending days of the first half of the decade that may have been the case, but, as we’ve all seen, the times they are a changing.So where are the opportunities today? We keep hearing the mantra “self-storage is recession proof.” Is this true? Absolutely not! Self-storage has proven recession resistant, but, a recession definitely affects the self-storage industry, especially a recession as long and drawn out as the current one. Resistance is all we need to maintain a strong asset in a down economy. Add the fact that self-storage is inflation neutral and you have a recipe for success independent of the whims of the economy.

“The best days for self-storage are ahead of us,” said Spencer Kirk, CEO Extra Space, at a recent California Self Storage Association (CSSA) meeting. I couldn’t agree more.

Let’s think about the mechanics of this. As the economy recedes, people and businesses downsize (or close down). This is an obvious perk for self-storage as storage needs are created with both of these situations. Recessions can also cause people to move in search of new jobs. Relocating can create a need, especially if people are moving with the intention of returning at some point. Businesses may also close down temporarily, or downsize, with the intention of reorganizing or expanding upon a macro-economic recovery.

But, what happens with an extensive and prolonged recession? What happens with double-digit unemployment numbers and a massive exodus of people, jobs, and businesses with no intention of returning? There is a tipping point. There is a point at which even the $50 a month for a small storage unit is just too much. Fortunately, we are nowhere near this point, but we are close enough to see weakness in rents and occupancies in certain markets.

These weaknesses are nowhere near catastrophic, as even in a weakened state self-storage investments are some of the strongest performers, certainly in terms of cash flow Real Estate, which we have seen in recent years.I hesitate calling this a weakness because the cash flow part of the business is still very strong and will continue to be strong, but it’s just not as strong as it was a year or two ago in certain markets; “certain markets” being the key operative phrase. If you are operating in established neighborhoods, infill locations, with little to no competition, you are probably doing pretty well. If you took the “if you build it, they will come” attitude and built in a new neighborhood, you are probably feeling the crunch of a slow absorption of new houses and slow lease-up schedules. Some of these markets can take four years or longer to stabilize from Certificate of Occupancy compared to 30 to 36 months in a well-established market. This can be a long and painful period of feeding carry costs and debt service.

Understanding The Issues

What this means to the developer is a higher and longer carry cost until the facility is paying for itself. This is also a very tough market to sell these facilities in because the actual value of an unstabilized asset may be below the replacement cost or cost of construction. Very few buyers want to take on the burden of an unstabilized product in this market. Does that mean opportunity? Of course it does! Personally, I wouldn’t build myself, but I would love to make a deal on the right new project by buying it from a developer who is “compelled” to sell. 

There are a couple of issues to address with the “value-add” deal. First of all, it has to be priced right. Since a cap rate doesn’t make sense on actual numbers, I’d value it on proforma numbers, but at a high cap rate, definitely in the double digits. It doesn’t make a lot of sense to value based entirely on replacement cost since there is a certain amount of risk involved in lease up that has to be accounted for in the current market. Hopefully, the phantom cap rate and the cost of construction come together and it’s a win, win situation for everyone, but this is a business opportunity and must be scrutinized as such.

The second problem is financing. Financing has a lot of people and businesses in trouble over the last few years and we will continue to see the fallout for a few years to come. Leverage is a valuable tool, but must be carefully considered. Relatively low leverage is fine on an unstabilized asset, but difficult for most operators to obtain as lenders are still a little gun shy about making these types of speculative loans. If you are well capitalized, it may make sense to just pay all cash for a lease-up deal. By doing this, you’re not under the gun to rapidly stabilize the facility to make debt service or coverage ratios. This is in addition to the fact that you will most likely be paying a higher interest rate on the note because of the increase in lending risk.

According to Kirk, Extra Space approached 250 banks and was only able to secure one loan. This is with a $1 billion balance sheet. Personally, I don’t believe the lending markets are quite that bleak, but you definitely have to turn over a lot of rocks to find a lender that meets reasonable lending criteria.

Depending on the market, you should assume a 36 to 48 month lease-up period and either sell or refinance after that to maximize your return. If you are able to stabilize the property to at least 85 percent economic occupancy, it should be easy to sell at a reasonable stabilized cap rate (seven to nine percent depending on the market) on real numbers. It should also be easier to leverage as the lenders will put value and safety into the fact that the property has exhibited stable and predictable cash flow.

So, what’s the opportunity here? The opportunity is to acquire unstabilized, newer facilities at bargain prices. Eventually, we will see a huge amount of value created in these properties, but this is a speculative play and not a cash flow play. So, it must be given its due scrutiny when establishing pricing and value.

Slow Down In New Construction

The difficulty in developing new projects, the main hurdle being access to reasonable financing, will create a tremendous amount of value in existing facilities. This is a necessary and welcome correction. The industry was just plain overbuilding. Even projects that have made it past the permitting and entitlement stage will most likely remain stagnant for some time if not forever. Even large operators such as Extra Space have halted new construction projects citing lack of appropriate financing. Obviously, the large public operators have to answer to their analysts and shareholders that very carefully scrutinize maturing debt and liquidity, so it makes sense that they would put a hold on new developments. For the rest of us, we are enjoying the benefits of uncorrelated assets that aren’t subject to the whims of stock analysts and stock markets.

 Obviously, with less inventory on the market, existing inventory should remain strong and grow stronger. I usually subscribe to contrarian thinking. In other words, if everyone’s getting rich buying widgets, it’s probably too late to get into the widget market. With this in mind, I have to contradict my contrarianism. I don’t see a lot of interest in developing new product. There are a few out there, but the general thinking is that it’s not a good time to be developing. The contrarian argument would be that this is the best time to jump into that market as there would be little, if any, competition. But given the overall state of the lending and real estate markets, I think we should hold off a little longer before jumping into speculation on new product. There will be a tremendous opportunity in this space once we see stronger growth in absorption, occupancy, and rents in existing facilities.

Stabilized Product

Here is where I see the biggest opportunity: Cash flow is on sale. This is a great time to own and operate cash flow real estate. It is one of the few predictable performers out there in terms of investment dollars. As of this writing, the DOW is slowly creeping upward, but it is a fickle and unpredictable beast. By year end, I wouldn’t be surprised to see it soar to 11,000 or drop to 6,000. However, here is the problem. All you need is a report on job weakness, institutional failure, or some missed target in an economic indicator to cause a precipitous fall, whereas raw exuberance about a positive indicator can cause it to soar. In other words, it is a great vehicle to make a lot of money or lose a lot of money.

We just don’t see that in self-storage. The returns are predictable. If you buy right and operate professionally, it is very difficult to make it worth zero. At a recent storage convention in Huntington Beach, Spencer Kirk posed the following question: “How many self-storage Assets have ever gone dark? I’ve seen one. Self-storage is not a distressed asset.” This is an important point. The asset class wants to perform. Very few have ever actually failed, and this is not considered a distressed asset class. There’s a lot of security in that. This is not a speculative play.

 According to Kent Christiensen, CFO of Extra Space Storage, who also spoke at the recent CSSA meeting, “The product is doing very well. We are still issuing rent increases on existing customers.” This reality gives credit to the general thought that self-storage continues to be a safe, predictable, and recession resistant asset. There is obviously a huge amount of opportunity here. 

Here’s the quandary. Well-capitalized and strong operators are hanging on to their stabilized product. The opportunity lies in the fact that very few of them are actually in the market to buy. There are deals out there where you can buy stabilized cash flowing class-A product at reasonable cap rates (expect anywhere from eight to 9.5 percent on actual numbers). I’d argue that the values of many of the stronger facilities lie in the seven percent range, but these are simply not trading.

What you need to look for is a seller who is compelled to sell. The seller must be either distressed or experiencing some other compelling reason to get out of the market or raise capital. Examples that we’ve seen include sellers with maturing debt that are unable to extend or modify their loans, cross-collateralized loans with underperforming assets are forcing operators to sell their performing assets problems in other parts of their portfolios that require cash to carry, and public companies that need to increase their cash position to satisfy analysts and shareholders.

For the most part, these sellers realize that it is very difficult to find a seven cap buyer in the current market. There are a few delusions of grandeur out there and these delusions have soured many deals. Time will correct all of these issues. But for now, it simply doesn’t make sense to buy a facility that won’t produce more than eight percent net cash flow out of the box. The main lever you have for adjusting the cash flow is, of course, the purchase price.

All things considered, a stabilized cash flow deal, bought right, should yield at least eight percent NOI after debt service year one and should have an all-in return with appreciation in the 20 percent range with a five- to seven-year hold. Where do you find these deals? In general, once they reach loopNet, it’s too late. The seller’s have been out in the market, their brokers have already approached the “usual suspects” trying to find a buyer, and the property is burdened with marketing and broker’s fees.

Finding an “off market” deal is usually your best bet, but it requires legwork. Sourcing deals from lenders is one approach. Often lenders are the first to know about distressed sellers and are more than willing to match buyers with sellers. Another approach is to simply approach operators in markets in which you are interested. Leave your card and tell them that you’re a motivated buyer. Eventually, you will start getting calls.

Enlist the help of your existing facility managers. If you have facilities in markets that you like, your managers should be conducting periodic market surveys as part of their normal duties. Have them approach other managers in the markets you like and get a read on whether there may be interest in selling. You never know what you might dig up. These managers are “locals” who should have a pretty good read on what’s performing and where the opportunities lie. 

Finally, don’t underestimate the breadth and reach of the brokerage community. Develop relationships and make sure the brokers know that you are a motivated and effective buyer looking for off market deals. They all have pocket deals and are more than happy to find a bona fide buyer. We all need to take care of each other, and of course, the broker needs to be paid a commission for his or her service. But, finding these off market deals will limit the costs the broker incurs marketing a deal and will often lead to a lower commission which is a cost to the buyer whether the seller pays it or not.

Going Forward

I have no idea if we are at the bottom, in the middle, or at a plateau in the economy. My gut feeling tells me that it is still not stable and that it will not be stable for some time. Once we begin the recovery process, it will be a long and slow road. First we will see unemployment peak and stabilize. After this, lenders will start getting their feet wet in this brave new world. Once financial liquidity starts to increase, jobs will increase, consumer confidence will increase, prices will stabilize, and the economy will warm up.

Then the stimulus hits. If it hits hard, we will see inflation and every one of us will be glad that we have investments in self-storage real estate.