By Michael L. McCune
As we start a new year and finish the current millennium, now would be a good time to take a break from reveling in our good fortune and take a hard look at where we are at the beginning of 1999. Wanting to be as accurate and unbiased as possible, I have asked a few industry gurus to give me a hand in this examination. While I have solicited their views and quoted them liberally, they are responsible only for their own thoughts and not necessarily those of the other experts or my observations and musings. To better organize this exploration, I have attempted to break the analysis into some meaningful categories.
Cap Rates
First let me refresh your understanding of capitalization rates. Cap rates are simply a shorthand method of valuing real estate, including self-storage. This is really a measure of the return that investors are willing to accept in owning the property and the quality of the project. Value (i.e., selling price) is simply the Net Operating Income (NOI) divided by the cap rate. For example, if the NOI is $1,000,000 and the cap rate is 0.11, the value of the property is $9,090,909. Likewise, if the cap rate were .095, the value would be $10,526,315. The cap rate is an easy way to relate value to the NOI and is the single most important variable in establishing value of self-storage facilities.
In other real-estate markets, cap rates have been quite volatile. For example, cap rates for office projects of similar quality have varied over the last few years from .12 to .08, and in some cases declined to .07. Hotels have varied from .13 to .08. Self-storage cap rates, for high-quality properties, have not shown the degree of volatility as in other types of real estate. With only small variances from the average .10 plus or minus, they have been relatively consistent over the last few years. When the REITs were very active in the high-quality market (1996 to early 1998), cap rates for the very best properties were competing for what might have been somewhat less than the adjusted average. For the most part, though, cap rates for self-storage haven't changed a great deal, even when cap rates for other real-estate types have changed by as much as 40 percent or more. Ray Wilson, of Charles R. Wilson & Associates, an appraiser that specializes in self-storage, keeps very close tabs on actual cap rates and has found the average cap rate is close to .10, with a very narrow range of variance. And remember that a cap rate is also influenced by the quality of the project, so not all projects will get the same cap rate.
What conclusions can we draw from these differences in cap rates between real-estate types? First, it gives us an indication that cap rates may remain more stable in self-storage than other types of real estate, even in less friendly markets. Also, I think it means that we have a very narrow and well-defined group of buyers that all think alike in terms of the returns they must receive. We will take a closer look at who the buyers really are later, but first let us think about what the effect of newly constructed facilities will have on the market.
New Facilities
With the real-estate market so strong in almost all parts of the country, it is no surprise that there are many projects that have been built, are under construction or seriously being planned. Clearly, the increase in new projects means existing facilities will have to share the market with these new and aggressive competitors. This will have an affect on both rents and occupancies if the demand for space doesn't keep up with the new development. Although banks have been more restrictive in their underwriting standards than they were in the 1980s, funds have been generally available for new projects.
It is almost impossible to get good estimates of the total area being added to the inventory of space, but we know that there is significant growth in many markets, especially in the metropolitan areas of the South and the West. The best indicators of what impact the new facilities will have on the market is to look at the trend of rental rates and occupancies. The latest national survey revealed an increase in vacancies and a modest decrease in rental rates. This would indicate that the new facilities are beginning to have an impact on the market in general. Since the economy has remained strong and demand for the product has not declined, these changes in rates and occupancies can generally be attributed to increases in supply and competition.
What's in the future? We know that there are many more projects in the "pipeline" and that if the economy takes a spill, demand will be affected. The combination of a slowdown in demand for space and the completion of more new projects could have a material impact on existing projects. The impact could be even more dramatic in localized areas where several new projects are being built and will compete for occupancy primarily by reducing price. Being alert to planned projects in your area is the best defense against nasty surprises in your market. Several of our brokers report that in some areas, as much as a 50 percent increase in space in a five-mile radius of some projects is likely over a relatively near-term horizon. This magnitude of overbuilding would certainly have dramatic negative implications for the projects involved. In the average project, a decline in rents of 5 percent and a decline in occupancy of 5 percent would likely reduce the value of a project by about 15 percent. Therefore, overbuilding is probably the single largest impact on future value of a self-storage project.
Financing
In the last five years we have seen many new lenders get into the self-storage market. Interest rates have fallen to the lowest levels in decades and the spreads (the amount added to the Treasury Bond rates to determine the loan rate) have seen a decline from 400 basis points (100 BP= 1 percent) to 150 BP at the lows. Everything seemed to be going well until October 1998, when we learned that even the self-storage industry could be affected by the problems in Asia. Suddenly and without warning, with interest rates still declining, spreads increased dramatically, causing some lenders to break commitments on loans and others to dramatically raise the quoted rates on loans not yet committed. Literally, within a week, many brand-name, Wall-Street brokers had essentially disappeared.
According to Neal Gussis of First Security Commercial Mortgage and Eric Snyder of Finova Realty Capital, the market has begun to recover, but the direction of spreads remains an open issue. Loan underwriting standards remain high with lenders having less flexibility to take a deal that is not "standard." Both spokesmen said that new minimum rates have been established that will disregard the Treasury relationship if it does not result in high-enough rates. This means that even if Treasury rates go lower and spreads decline, the loan rates will not go back to the absolute rates seen earlier this year.
Several of Argus' brokers report that some banks--though not all--have tightened their requirements for self-storage construction loans and, in some cases, have even gotten out of the self-storage business entirely. This situation has a positive aspect in that it may reduce the number of new projects that are built. However, there are also some negatives for the owner that wants or needs to sell to a bank-financed buyer. It is clear that it will be more difficult to obtain loans for prospective buyers even if rates stay down and spreads continue to narrow.
I asked both finance experts to give us their best thoughts on the direction of interest rates. Each thought that in the near term the rates would not likely rise much or even fall a little, but added that spreads may continue to be volatile for some time to come. Both Snyder and Gussis remain concerned that some international financial crisis could again change the entire financing landscape overnight. Each also cautioned that there is still concern in the commercial-backed mortgage security market that investors have a preference for Treasury notes making it more difficult to provide funding for the self-storage industry. In summary, the good news is that there is well-priced financing available for purchasers, but there is also substantially more uncertainty in the financial markets and more rigidity in the underwriting process, which will make selling somewhat more difficult than in 1998.
Where are the buyers?
This question really has two parts. The first part relates to what happened to the REITs and the "wannabe" REITs. Over the last couple of years, many owners became quite sanguine that they could always call a couple of REITs and get a bidding war going for their property if they wanted to sell. The truth of the matter was that this was never really true. Even when the REITs were very active prospectors for new projects, they were generally very careful, analytical buyers and only bought from the upper levels of quality projects. The rumors of excessively low cap rates paid by the REITs were as much a function of the various definitions of NOI, more than it was genuinely low cap rates. Also, many of the REITs had begun to shift their strategies to building new projects rather than buying existing properties, because they felt that returns justified the risk.
When the stock market took its tumble, the REIT stock prices were down significantly, impairing and interrupting their access to capital. As I write this, the stock market has smartly recovered most of its losses, but many REITs are still selling at significant discounts to the highs of the year. One REIT was even acquired by another, as it was cheaper to buy properties that way than to buy them on the open market. The REITs will continue to remain a major buyer of properties in the future, but they will be even more selective and sensitive to value. If there is some major revaluation in the stock market, the REITs buying will certainly be further restrained. The REIT demand for facilities will be concentrated in the high-growth metropolitan areas where they can achieve management efficiency and will generally be for the best self-storage properties.
The balance and majority of buyers will come from sources that have been traditional in the self-storage industry: other self-storage owners. While there has been much made of the industry's new visibility and acceptance by investors of other types of real estate, the fact remains that current self-storage owners buy the vast majority of all projects that are sold. Although there has surely been some new interest and acceptance of self-storage on the part of institutional investors, that demand has largely been met through investing in the shares of REITs. Large institutions simply are not geared to making the relatively small transactions that are necessary in buying individual self-storage facilities. Brokers across the country see very little evidence that there are many new buyers in the self-storage market for individual properties. They see a lot of "Looky Lous," but rarely do they turn into credible prospects or buyers. A few current owners have forged deals with large investors--such as pension fund advisors--to provide capital to purchase properties, but make no mistake, they are experienced self-storage owners. As I mentioned earlier, this has tended to make the cap rates less volatile because most owner-purchasers have a similar perception of the risk and returns involved in self-storage. In the future, as in the past, the majority of serious buyers will likely be sophisticated and experienced in self-storage operations and valuations because they are current owners. As financing regulations become more restrictive, it will be the experienced builder/buyer who gets the job done. Inexperienced buyers will have a more difficult time acquiring sites.
Summary
One word seems to define the future market: uncertainty. There are some negatives, to be sure, on the horizon, including such things as financing availability, economic slowdowns or recession and the investment direction of the REITs. However, there are also many positives that remain in the market: the consistency of cap rates, the demand of current owners for additional facilities and restrictions on financing that may prevent further overbuilding. The consensus of Argus brokers is that the most likely scenario is that the first part of 1999 will remain a seller's market, but with more difficult transactions. As to the later part of the year and into the new millennium, the market will by then have determined its direction and we will have a clearer view of the future. But the odds seem to be against continuing to duplicate this almost magical set of circumstances that have driven the market over the last couple of years.
Michael L. McCune is president of Denver-based Argus Self-Storage Sales Network. For more information, call (303) 299-8820 or visit the company's Website at www.selfstorage.com.
