The Best of Times

It was the best of times, it was the worst of times, begins Charles Dickens classic, A Tale of TwoCities. Today's self-storage market is the best for owners and buyersmore than at any time in the existence of our business. Better still, the worst of times has no place at all on this page of history, at least not at the time of this writing.

Interest rates are low, lenders are aggressive, buyers can earn a highly competitive return when purchasing facilities, large institutional investors are buying self-storages, and values of properties are at all-time highs.

Seismic Changes

Many self-storage owners have focused on day-to-day operations and are only casually aware of the changing commercial real estate world. But change in the last three years has been seismic. The chart illustrates how a typical projects value has been influenced by the real estate market. Notice that the property generated exactly the same income each year; only the change in the market cap rate has affected its value. This shift is even more dramatic if increases in equity value are considered.

We can draw some interesting conclusions:

• 26 percent increase in value solely because of change in cap rate 
• Increase in equity of 100 percent or more 
• Loan-to-value ratio change from 75 percent to 59 percent 

Cap rates in commercial real estate determine the way income from a property is capitalized to determine value. Cap rates are set in the marketplace and generally have a strong relationship to interest rates and returns of other competing investments such as stocks and bonds. They can vary by geographical areas, quality of construction and local markets.

Cap rates for all kinds of commercial real estate are at historic lows. Its clear from our example that self-storage owners are extremely likely to have experienced greater values over the last three years than any other time of ownership.

Future Speculation

While its comforting to have prospered in recent times from this extraordinary market, several questions hang over the future. Its wishful thinking to wonder if high values will lastthey never have! Cyclical trends in real estate, stock markets, interest rates and skirt lengths are just a fact of life and have been with the human race since we began trading donkeys.

The more typical historic range for cap rates has been in the 8.8 to 11 range. We dont have the slightest evidence that volatility in cap rates and the resulting values have been permanently terminated.

What About Values?

An interesting but more complex question is values. Two elements generally determine value: net operating income (NOI) and the prevailing cap rates in the market. Thus, if your NOI increases measurably, the value will rise if cap rates stay the same. However, the value may actually decline if cap rates rise dramatically.

Lets see how the numbers work if the NOI and cap rates increase. Using our same hypothetical project, notice rising cap rates can materially impact value and equity even with an increase in NOI. Scenario 1 shows our project as described above, with a 7.5 percent cap rate. In Scenario 2, we increase the NOI by 6 percent, but keep the cap rate the same. This results in an increase in both value and equity.

In Scenarios 3 and 4, we increase the cap rate but keep the same NOI. Notice the dramatic decrease in value and equity to a level lower than when the project had a smaller NOI.

Changes in cap rates can be more important than fluctuations in NOI in determining value. Cap rates are at all-time lows, but its difficult to predict if they can go lower. The fact that interest rates have stabilized and are creeping up suggests cap rates may have stopped their three-year decline.

According to an article in a recent real estate newsletter, cap rates were going in the red zone. This means they exceed 10-year Treasury rates by less than 2.5 percent; investors may view the returns as inadequate compared to other investments. While there may be some minor compression in this 2.5 percent, the general consensus may be lenders and buyers become jumpy below those levels.

New Buyers

Over the last five years, many private real estate funds have been formed by major financial groups that invest for the benefit of large pension funds and foundations. The values on other types of commercial real estate have seen dramatic increases similar to self-storage. Typically, these funds are measured in the billions and invested in projects such as large office buildings and regional shopping centers.

However, because of the compression of the cap-rate spreads in those real estate classes, the funds are starting to look at niche product types like self-storage. While they often prefer to buy large portfolios, were seeing interest in developing acquisition programs for these groups. Meanwhile, current storage owners continue to enlarge their portfolios.

The Plan

Were living in an extraordinary time. Evaluate your circumstances and decide if your should take advantage of todays climate. If the plan is to keep your facility for at least five years, and you believe business can grow incrementally despite your competition, make sure youve captured a low interest rate on a loan for at least that term.

If your ownership horizon is less than five years or youre concerned about your long-term ability to compete in the market, then selling might be an attractive option. Values are high, capital gain rates are low and the chance of cap rates going up (values going down) appears to be significant.

Finally, if youre teetering on a decision, make one as soon as youre comfortable. While no one has the ability to predict where rates and values will be a year from now, we can be sure the best of times wont last forever. 

Michael L. McCune is president of the Argus Self Storage Sales Network, a self-storage real estate brokerage and development company based in Denver. Argus also operates www.selfstorage.com, a marketing medium for owners in the self-storage industry. For more information, call 800.55.STORE.