What are two financing facts many storage owners are surprised to learn? One, there are more types of permanent, bridge and construction loans available today than at any time in the history of the industry; and two, lenders are more likely to add custom loan terms and features, even for permanent loans, if a facility has a positive track record or a new property has consistent lease-up.

Whether you are trying to fix your cost of capital for a newly or nearly stabilized property; obtain permanent financing to replace maturing, long-term debt; secure bridge financing to take out a construction loan or buy out an equity partner; or secure construction-loan funding for a development in a good market, its a great time to seek financing. However, its important to have an existing property with a positive history or a development site with a competitive advantage in a strong market to lock in the most competitively priced capital.

Permanent Loans

Many investors believe there is only a small price variation and minor differences in loan structure from one lender to the next for long-term, fixed-rate, permanent financing. The good news for owners is this is far from the truth in todays aggressive lending market. One reason for the pricing differential is there are still only a handful of capital providers who fully understand storage as a property type and have a track record of trading self-storage paper in the secondary market.

As most investors know, permanent loans are used to take out floating- rate construction or bridge loans, typically with long-term, fixed rates. The goal of the permanent loan is to secure sufficient proceeds to pay off the construction loan and return most or all of the original equity capital to the developer-owner and any investor partners. With fixed interest rates at 40-year historical lows, most investors are pushing to lock in their cost of capital, whether they are taking out a loan, coming out of an existing fixed-rate loan with a yield-maintenance or defeasance prepayment penalty, or purchasing a new facility.

At the writing of this article, it is possible to obtain five-, seven- or 10-year fixed rates in the 4.75 percent to 5.75 percent range at loan amounts up to 80 percent of value. If you are looking for a loan that is 65 percent loan-to-value or less, you can obtain a 10-year fixed rate in the low 5 percent range. Most of these loans are amortized over 25 or 30 years and funded by lenders who trade them as part of a billion-dollar portfolio in the commercial mortgage backed securities (CMBS) market.

The exception would be a life-insurance company, which usually cant match the same leverage and low cost of todays CMBS or conduit loans. It may, however, provide a shorter-term, fixed rate-loan with a declining prepayment-penalty schedule during the last several years of the term. The other exception is a local bank that will offer a fixed rate to a preferred customer; however, it is very rare that a local bank can compete on rate or loan proceeds with a CMBS fixed-rate loan.

In the past, it was the intent of many owners who secured long-term, fixed-rate loans to hold onto their properties over the long haul. This was because they knew the loans were essentially prohibited from prepayment due to the high cost of yield maintenance or defeasance. Also, at the time, rates in the 8 percent to 9 percent range were attractive compared to the double-digit rates previously available.

However, since we are most likely at the bottom of the interest-rate cycle, even owners who have a short-term investment horizon are placing long-term, fixed-rate loans on their properties. They either believe the prepayment penalty will be nominal at the time of payoff, or they want to lock in these low rates to make their properties more marketable. Owners who secured fixed interest in the 8 percent or 9 percent range years ago are looking to replace it a rate below 6 percent. Consequently, the defeasance or yield-maintenance calculations add up to an onerous prepayment penalty.

Recent trends in permanent financing include the ability to lock in all or the majority of loan proceeds for a facility that is still in its final stage of lease-up by working with a lender who will offer a customized loan structure. One example is bridging the shortfall of net operating income needed to qualify for the desired loan amount with a letter of credit.

Another example is structuring an earn out, whereby you fix the majority of loan proceeds today and earn out the balance by increasing net operating income over a six- to 12-month period. Furthermore, lenders are willing to offer leverage exceeding the normal 75 percent loan-to-value limit and 30-year amortization on a case-by-case basis.

Finally, it is important to understand that to qualify for low, fixed-rate loans, you must be able to satisfy requirements mandated by the secondary or CMBS market. specifically, you will need to form a Single-Purpose Entity as the ownership body of the property. This means you cannot own the property as an individual, and the entity you form cant be engaged in any other business than the operation of the facility.

Bridge Loans

The purpose of a bridge loan is to provide a relatively short term with little or no prepayment penalty, during which time an owner can maximize the income potential of a property before securing long-term, permanent financing. This may include an added-value purchase to increase occupancy and net operating income at a facility that has been poorly managed, or an expansion for an owner with the ability to increase revenue by adding net rentable square feet. A bridge loan may be used to provide stabilization of an asset with a maturing construction loan that has experienced a longer lease-up period. A lower-interest, nonrecourse bridge loan may also be used to replace a recourse construction loan with a higher floor interest rate.

Depending on a facilitys economic occupancy and corresponding debt-service coverage ratio (DSCR), bridge loans may be non-recourse, recourse or partially recourse. Most are priced over LIBOR, though some banks still base their loans over the Prime Rate. The LIBOR-based pricing for many bridge loans is in the 4-percent to 5.5-percent range, depending on the degree of leverage, the quality of the asset and the financial strength of the borrower.

The exception would be borrowers who qualify for bridge loans offered by national money-center banks. These institutions may provide a partial-recourse loan that burns off for properties that have reached or surpassed the breakeven DSCR. These bridge-loan rates are in the 3.5 percent to 5 percent range. Its important to note that if your bridge loan is nonrecourse, the nonrecourse applies to most everything except fraud, misrepresentation and environmental contamination.

Flexibility is a key aspect of a bridge loan. The borrowers exit strategy is to move into a permanent fixed-rate mortgage or sell the facility; therefore, the financing cant be constrained by a significant prepayment-penalty structure. Another potential feature of a bridge loan is the ability to negotiate an earn-out component to receive additional loan proceeds based on increasing the properties income. This may involve the expansion of anexisting facility or be as simple as increasing the occupancy and income through improved management.

Furthermore, the length and terms of bridge loans vary, and most of them have either no lock-out period or a very short one in which prepayment is restricted. If they have a prepayment penalty, it is relatively low and goes away in a short time. For example, some bridge programs are locked out to prepayment during the first year, a 1 percent penalty in the second year, and decline to no penalty in the final year.

A recent trend in self-storage bridge lending is the ability to fund loan proceeds equal to 100 percent of total project costs to facilitate the buy-out of a partner or an outright purchase from a third-party owner. One big difference between a bridge and a construction loan is if there has been enough seasoning at a property, the lender will offer significantly more loan proceeds equal to 75 percent of appraised value, as opposed to the 75 percent 80 percent of project-cost leverage restriction found in a typical construction loan.

Construction Loans

Construction loans are typically provided by money-center banks, strong regional banks or smaller local banks. This is true whether you are building a new facility from the ground up or expanding an existing one. It makes sense to call an experienced self-storage lender with whom you already have a working relationship, because it will likely offer the most aggressive loan terms, rate and structure. However, some borrowers will benefit from the services of an experienced mortgage banker or broker when it makes sense to build a new relationship, or they want to take advantage of a competitive bid process between multiple banks to ensure they secure the most aggressive loan possible.

The market is always changing. Some banks are extremely competitive during one quarter, only to exit the market the next quarter because they have reached their self-storage lending limit. This is why it makes sense to nurture multiple relationships. Once you have selected the bank that best meets your needs, its important to understand its underwriting criteria for the borrower and property to avoid misunderstandings during the loan process.

If you are starting a new banking relationship, understand that most banks will want to see experience successfully building and stabilizing self-storage properties. They will also want to review the results of a professional feasibility study. The most competitive construction lenders require full recourse or personal liability to the individual principals; therefore, they will scrutinize your personal financial statement to determine if you meet their net worth and liquidity requirements. The rare exception to this is when a financially strong borrower convinces a bank to accept recourse only to a specific entity, and then capitalizes the entity to a level that satisfies the bank.

Next, the bank will completely analyze your monthly construction, lease-up and operating pro forma, which will include your projections of rental income, economic occupancy, number of months to stabilization, expense ratios, etc. Your projections will be compared to the market, so you must make a strong case. Furthermore, your projected costs to build the facility will be compared to those of other facilities recently developed in the area.

Once you meet the banks lending criteria, you can secure a low interest rate, which can range from 3.5 percent to 5.5 percent for a loan that provides up to 75 percent or 80 percent of total project-cost financing. The range in interest rates is based on your developers financial statement, the type of bank interested in the project, your storage track record, the size of the loan request, the market demand for the facility, and the quality of the projects location.

If you have a net worth of approximately two times the loan amount and at least 10 percent to 20 percent of it is liquid, you might qualify for one of the money center banks financing programs. These institutions generally offer LIBOR- or Prime-based rates in the 3.5 percent to 4.75 percent range. That said, they have very different qualifying criteria. For example, some will not budgeoff their 10 percent to 20 percent liquidity requirement and will ask that you maintain that liquidity through the entire construction- loan period. Others will allow minimal liquidity as long as you have a strong track record of developing and stabilizing storage facilities and enjoy a significant annual cash flow from your portfolio.

If a money-center banks criteria are too stringent, one of the strong regional banks that offer the same LIBOR- and Prime-based rates but typically use floor interest rates in the 4.75 percent to 5.5 percent range can be a great source of capital. These loans usually provide for a three-year term with a one-year extension option; a two-year term with two six-month extension options; or similar terms and extension options.

There are some non-bank institutions that offer non-recourse or partial-recourse construction financing. These lenders are rare and are typically selective as to the types of deals they will fund. Because their only recourse is to the real estate, there must be strong market evidence to support the demand for your project. One attractive feature to this higher-cost construction financing is it may provide up to 85 percent loan-to-cost financing. Today, these lenders have floor interest rates in the 6 percent to 7.5 percent range. They may charge higher origination fees and/or exit fees and may include prepayment penalties in their loan structure.

Whether or not construction lenders require personal guarantees/recourse, their pricing is based over LIBOR and Prime, so your rate will most likely adjust during your loan term. It is important a developer factors in the impact a floating rate loan may have on his cash-flow projections and corresponding return on investment.

Recent construction-lending trends include the ability for money-center banks to offer an option with a significant net worth and liquidity, with the lowest LIBOR-based construction loans, to swap out their LIBOR-based, variable- rate financing for a fixed rate for 12 or 24 months. The cost to swap the rate varies, depending on what the interest-rate futures market believes will happen over the next couple of years. Another trend is for lenders who understand storage to offer longer construction- loan terms, like 36 months, to give facilities time to stabilize.

The good news is owners enjoy a wide variety of competitive financing options and are benefiting from some of the lowest interest rates in history. Todays variable-rate loans are priced over LIBOR or Prime, both of which are at historical lows. When lenders add their margins or spreads to these indices, it equates to variable-rate loans from the mid-3 percent to the mid-5 percent range. The fixed-rate lending market is just as favorable. Most fixed-rate loans are priced over U.S. Treasuries, also at historical lows. Add the additional spread to todays 10-Year Treasury, and its possible to obtain loans in the high 4 percent to the high 5 percent range for five, seven or 10 years.

Jim Davies and Eric Snyder are principals of Buchanan Storage Capital, which delivers debt and equity capital to the self-storage industry nationwide. For more information, call 800.675.1902; visit www.buchananstoragecapital.com.

Have you ever measured the incoming phone calls your store misses? What about walk-in customers? What impact do these have on your bottom line and potential real estate value? It would probably shock you to know just how powerful this information can be. How do you improve your selfstorage rentals and enhance the worth of your property? Sales training.

As the industry becomes more competitive, it is crucial to develop an ongoing training program that will continually improve the performance of your salespeople. It would be a shot in the dark to implement sporadic training out of fear of failure. This would be a waste of time, energy and money, and could even be detrimental to employees performance. If you dont feel comfortable conducting your own staff instruction, consider using a professional company that specializes in training to help you identify areas for improvement within your organization. It can provide direction on a regimented sales program to continually improve the skills of your entire team.

Success in the area of sales is a long-term journey. It involves doing things well and consistently, day in and day out. Accomplishment occurs along the way. If you think you have arrived, be carefulthis is about the time you become complacent, and the competition passes you by. If you have found the magic recipe for a highly effective sales program, good for you. It will take you to higher levels of success and guard your operation from competition as the industry continues to grow.

First Things First

The new generation of self-storage has become more sophisticated in the appearance of its stores, but it has lagged in the understanding and development of more effective training programs. Operators should perceive their facilities as retail operations, educating and building value with customers and earning the right to make the sale. This means guiding employees in the process of enticing and serving prospects.

The first key area to examine is your phone-sales presentation. In most cases, this is the initial interaction between your facility and the customer. It will dictate the overall impression a prospect has of your store and determine if he visits you. Industry statistics tell us that 90 percent of the time, if a customer actually visits a store, he will rent a unit. This reinforces and validates the importance of phone sales. Training in this field can make a significant difference in the opportunities you are given to earn new business.

Ongoing Efforts

Once you provide proper training for your employees, you must have a system to continually update that guidance. The initial training is only as good as its ongoing reinforcement. If you hire a training company, it can help you develop systems for continuing improvement. For example, having a trainer come in a couple of times each year will help you provide new information and ways to incorporate suggested improvements into daily work routines. It will also provide a basis from which to work in terms of raising the standards of acceptable performance. Keeping people on the learning curve also enriches their job responsibilities and creates better morale within the organization.

Another method for reinforcing training is a mystery-shopping service, which can act as a measuring stick and pinpoint areas for improvement in the sales presentation. If youre going to use this service, it is critical for everyone involved in the selling effort to be shopped consistently. This will raise the overall level of performance, as it involves employees in their own evaluation process. Use a mystery-shopping service that specializes in self-storage, as it can better customize the procedure and provide individualized coaching when necessary.

To take your storage operation to the next level, understand the importance of the sales program. The telephone is one of the most powerful tools you have. If used to its greatest advantage, it can set you apart from the competition. Budget for the ongoing training and development of your people, and you will set your facilities for success as the industry evolves.

Brad North is founder of Advantage Business Consulting, which specializes in on-site sales, marketing, feasibility and operational training for the self-storage industry. He has produced two live videos and a workbook titled Maximizing Your Sales and Marketing Program, which can help managers improve their sales and marketing efforts. He most recently launched A TelePro, a mystery-shopping service that assists in educating, evaluating and improving the phone-sales performance of self-storage professionals. For more information, call 513.229.0400 or visit www.advantagebusinessconsulting.com.

Construction Corner is a Q&A column committed to answering reader-submitted questions regarding construction and development. Inquiries may be sent to [email protected] .

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Q: I am about to install a new keypad-access system at my gate and would like your opinion on adding intercoms at the same time. Are they worth the time and money?

Dale in Hemet, Calif.

A: Amazingly, intercom systems are pretty inexpensive, especially when you install them at the same time as new keypads. I recommend using them. From an installation standpoint, it involves just another wire per keypad. From an end-users perspective, it shows you want to stay in contact with customers. Often, having an intercom at a gate keypad will save a tenant from having to get out of his car to go in the office. This is appreciated, especially in inclement weather. It also allows the manager to communicate with a tenant without leaving the office.

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Q: I am in the process of building my first facility and am at the point where I need to decide whether to install an exit keypad or just use a ground loop. Which do you prefer and why?

Julio in Beaumont, Texas

A: I recommend the exit keypad for a few reasons. First and foremost is site control. Without an exit keypad, you have no idea how long a tenant stayed on site or when he left. Another reason is it allows you to control tailgating. If someone (tenant or otherwise) was to follow a tenant into the facility, it would be harder for him to get out with a properly configured exit keypad. Finally, if your site is going to have any type of door-alarm system, the exit keypad will be used to re-arm a tenants unit when he leaves the site.

Tony Gardner is a licensed contractor and installation manager for QuikStor, a provider of self-storage security and software since 1987. For more information, visit www.quikstor.com.

Mike Parham, founder of Texas-based Noahs Ark Development, heard a call to create more than a successful self-storage business. In 1996, he formed the In His Steps Foundation (IHS), a nonprofit organization designed exclusively for charitable, religious and educational purposes. Numerous charities, students and churches have benefited from IHS funding. The seed of it all was planted by one little boy with a heartbreaking story: Russian-born Andrey McNaughtan.

During a pastor visit to Santa Rosa Childrens Hospital in San Antonio, Parham met Andreys adoptive mother, schoolteacher Pam McNaughtan. She told him of the boys brief and already harrowing past. Before his first birthday, Andrey was abandoned and left to die in a Russian orphanage. Born with nearly half his right ribcage missing, Andrey had an underdeveloped lung. He also suffered from severe congenital scoliosis, a misshaping of the spine.

When Andrey was 2 years old, Pam and Greg Roberts of New Zealand adopted him with little knowledge of the seriousness of his condition. A pediatric-orthopedic surgeon explained the urgency of a titanium-rib implant surgery to save the boys life. However, the technology was only available at Santa Rosa. Each visit would cost the family approximately $35,000 in New Zealand currency; 30 visits would be necessary throughout Andreys early years.

Inspired to help, Parham developed IHS to raise funds for the surgeries. Andrey is now an active 12-year-old, expected to live a long and normal life because of technology and the love of others, says Erin Keene, director of marketing for Noahs Ark Development.

Good Works

Since its first charitable mission, IHS has continued to aid those in need. The organization gave financial relief to a family whose provider was unable to work due to muscular scoliosis; a local church brought attention to the mans hardships. In the spirit of teach a man to fish, the charity helped family members establish a home-based business to ensure they would have a livelihood into the future.

Every Thanksgiving, IHS supports the Eagle Scout bunk-bed project for the local Miracle Mansion. The effort enables hungry families to eat and celebrate together, and homeless families to sleep safely and warmly. IHS also donates to the Ronald McDonald House.

Recently, IHS awarded five recipients for its Col. Clayton R. Eldredge Memorial Scholarship, which assists college-bound students in financial need. The scholarship requires students maintain a 2.5 grade point or better. This years winners are:

• Leigh Gregiore, second-year student at Abilene Christian University
• Alexis S. Pack, first-year student at Blinn Junior College
• Bobbi Martin, first-year student at Oklahoma Baptist University
• Peter Lewis, second-year student at University of Texas San Antonio
• Fritz Loeschel, first-year student at University of Texas San Antonio

Act of Faith

Parham doesnt stand alone in his dedication to IHS. The foundation is funded by the employees of Noahs Ark Development, NDS Construction and Joshua Management Corp. Victor Lopez, president of NDS Construction, is a trustee as well as a contributor, as is Leatine Fasano, vice president of Noahs Ark Development. Fasano also oversees the foundations books, gifts and contributions, and correspondence. Other donations and labor for upcoming church-building projects will come from many of the companies employees.

Parham says giving is an act of faitha duty inseparable from his deep religious beliefs. Those who give from the heart understand they are only stewards of what they have received, gratefully knowing God is the rightful owner, he says. Therefore, whenever they are called to give, they do it without question.

The religion-based IHS organization takes pride in participating in outreach programs to spread Christian teachings. Through the Mission of Mercy-Bethesda, the foundation supported 36 children in several Third World countries. IHS also contributed $18,900 to Mission Resource to build a chapel in Romania. Foundation members intend to do far more than donate dollars to the projectthey want to physically go over to help in the construction of the church and to witness to the community, Keene says. Due to political unrest in the area, however, the foundation has been forced to delay travel plans until a tentative departure in 2005.

As IHSs charitable activities reach beyond the borders, they stand as a clear testament to the influence of one human beings inspirationand the power of a single child to serve as spark.

Noahs Ark Development, based in Bulverde, Texas, is the producer of the Noahs Ark Self Storage chain in Florida and Texas. NDS Construction has designed and built more than 250 properties totaling more than 8 million square feet in the past 20 years. Joshua Management is the property-management firm responsible for the day-to-day leasing and operational activities of the Noahs Ark chain and a variety of other properties for investor groups. For more information, visit www.noahsgp.com.

A guy decided to go on a diet and announced it to his friend, who was happy to hear it and in full support of the idea. After a month, they bumped into each other in the mall. The friend asked how the diet was going. The guy responded, Really good. I feel a lot thinner these days. Perplexed, the friend asked, Thats interesting that you feel thinner, but how much weight have you lost? The response: Oh, Im afraid to get on the scale!

Many storage operators are afraid to get on the marketing scale. Theyre scared to measure the results of their efforts for fear of what they may or may not find. But they should realize you can only make good decisions if you have good data! To get good data, you have to track your numbers.

In the storage industry, there are some key facts to follow. Keep your eyes on them, and you will always be able to adjust your marketing efforts to ensure the greatest success. There are three important elements to making this work. First, you have to know which numbers to track. Then you have to know how to track them. Finally, you have to know what do to move the numbers in the right direction.

All of these figures are best evaluated on a monthly basis. A weeks worth of data would be too little and anything from longer than a month wouldnt allow you to make adjustments quickly enough. In this Internet age, you also have two sets of figures to track: your offline and online numbers. As an operator, youve got to fire your guns with both barrels. Neglecting either of these will put you at a competitive disadvantage.

Offline Numbers

1. How many calls do you get?

Whether you track this number manually or using a sophisticated phone system, you need to know how many calls you get each month. Since most of your marketing efforts are geared toward getting people to pick up the phone and call you, this is an essential element. If the phone isnt ringing, your marketing efforts arent working. A phone call normally precedes a rental. If youre in a high-traffic location, youll probably get a lot more people who just walk in without calling fi rst, but even then a phone that isnt ringing spells trouble.

2. How many of those calls result in visitors to your facility?

The percentage of people you convince to visit your facility lets you know how effective your phone skills are. If you cant get prospects to come to the store, you need to work on your phone-sales technique. If your closing ratio is below 50 percent, you have a problem.

3. How many of those visitors rent a unit?

The percentage of people who rent from you after a visit shows how good your sales skills are on a face-to-face basis. If prospects have made the effort to visit you, chances are good they will rent a unit. In fact, on average, more than 90 percent of visitors will buy. If your percentage is less than 90, you need to work on in-person sales.

4. How many referrals do you receive each month?

How many times each month do elated customers give you a list of prospects for your manager to call? Lets admit it, this is wishful thinking, but referrals are critical to success. Why? Aside from repeat customers, they represent the cheapest form of marketing.

You need to do everything you can to encourage referrals. In addition to the obvious task of treating customers extremely well, you also need to let them know you want referrals. Ask for them, and make sure to thank tenants when they give them to you. You may also want to provide incentives for those who refer.

5. What is the average length of stay of each customer?

This has a huge impact on profitability. If you can get existing renters to stay a few months longer than average, it will dramatically increase your revenues and you wont have to spend nearly as much on finding new customers. Treating people right and making their storage experience pleasant and enjoyable will help extend the average persons tenancy. Many will stay longer than they need to because youve made it comfortable and easy to do so.

6. How happy are people with their experience at your facility?

Numbers in this area tell you whether youre giving customers the service they expect. Provide lousy service, and it will come back to bite you. Everyone knows and preaches that service is important. The problem is few have a quantifiable method to let them know where they stand.

Ideally, your customers should be surveyed by phone. Given that this is extremely expensive, however, consider at least having a postcard people can fill out when they visit or move out of your facility. Keep it short, with a maximum of five questions that ask them to rate your site and service on a 1-to-5 scale. This is not an extremely sophisticated tracking tool, but it will give you an indication of where you stand and which way the numbers lean.

Online Numbers

1. How many unique visitors hit your website each month?

Unique, or new, visitors represent the true numbers as they relate to your site. If someone hits your site on 10 occasions, he should not be counted every time.

Talk to your webmaster to make sure you can separate new visitors from repeats. The numbers are there, its just a matter of extracting the data. This is similar to tracking the number of calls you get offlineits the key indicator of how good your marketing efforts are.

2. How many of those people request information?

Just like a properly handled phone presentation, your website should convince visitors to take a specific action. The three desired responses from web prospects are that they 1) request information, 2) call you on the phone or 3) visit your facility. Keep track of each of these actions to evaluate the quality of your online marketing.

3. How many of those prospects become customers?

You want your website to incite prospects to action. You want the benefits and features of your facility to inspire them to rent. Again, if you can get people to visit you, nine times out of 10 they will rent a unit. Remember to always ask prospects where they heard about you, whether it be a Yellow Pages ad, a referral from a friend or an Internet search. Tracking where your renters come from is crucial to spending your marketing dollars in the right places.

I have only one sign up in my office. It reads, Measurement Eliminates Argument. There can always be discussion on how to improve the numbers in your business. There should never be a question of what the numbers are. Track the figures mentioned above and youll be able to make the most intelligent decisions regarding the marketing of your storage facility.

Fred Gleeck is a self-storage consultant who helps owners/operators during all phases of the business, from the feasibility study to the creation of an ongoing marketing plan. He is the author of

Secrets of Self Storage Marketing SuccessRevealed!, available for purchase at www.selfstoragesuccess.com. He is also the producer of professional training videos on self-storage marketing. To receive a copy of his Seven-Day Self-Storage Marketing Course and storage marketing tips, send an e-mail to [email protected]. For more information, call 800.FGLEECK; e-mail [email protected].

Tobegin, a cap rate is An income rate for a total real property interest that reflects the relationship between a single years net operating income expectancy and the total property price or value; used to convert net operating income into an indication of overall property value (The Dictionary of Real Estate, page 255). When I began appraising nearly 20 years ago, I took courses in capitalization theory and techniques from The Appraisal Institute. Instructors simplified the cap rate by reminding us it is an overall return: to land and building and mortgage and equity. For now, just remember IRV, income divided by rate equals value.

Still confused? A cap rate is to real estate is what a dividend is to stock. It is one measure of the performance of an asset. Now think about the implications. A low return usually implies a high value. Conversely, a high return implies a low value. The return on cap rates can be measured in a number of ways. Appraisers usually look at comparable market data with an alternate technique based on mathematics. This is illustrated by the following example.

Overall Capitalization Rate

The cap rate is calculated by dividing the net operating income by the sales price. Ideally, it is selected from the market through sales of similar property types. The data is based on the rate considered by the parties involved in the sale to be the most relevant.

The data indicates a range of 100 basis points (8.50 percent to 9.50 percent), suggesting further tools of analysis are warranted. To assist with understanding the motivations and expectations of market participants and to provide a foundation for yield analysis, more techniques are presented as follows.

Simple Band of Investment

The simple band of investment is a comparison of financing and equity components. It considers the appropriate return to capital (usually considered interest on a mortgage) and return to equity dividend or on equity. In Table 2, the assumptions are market-based and concluded to be a 6.50 percent mortgage rate with a 25-year amortization at a 70 percent loan-to-value.

The equity component is based on the ratio of equity and forecast dividend, sometimes called cash-on-cash. Over the past several years, investors demands regarding dividends have increased. They want an immediate return rather than relying primarily on appreciation for yield. In comparison, common stock dividends for the 500 index published by Standard & Poors average around 1 percent. Alternatively, real estate investment trusts (REITs) for self-storage indicate an average annual equity dividend range from 2.70 percent to 6.58 percent.

REITs are considered less risky by some portfolio managers because they are more liquid and diversified than a single real estate asset. Conversely, some consider individual assets less risky because they are not as subject to wide, short-term yield swings due to fluctuating trading cycles. Historically, individual assets have been more stable. Under these parameters, the indicated simple band of investment is detailed in Table 2.

The weakness and strength of the band of investment is simplicity. It is easy to use, but does not dynamically account for changes over time. In this asset class, however, static or direct analysis is the preferred capitalization methodology.

Debt-Coverage Ratio

The debt-coverage ratio is the ratio of net operating income to annual debt service. This method is a useful tool for lenders and other fiduciaries because it underscores the safety of the investment by analyzing the ability of the asset to cover debt service. In this regard, the debt coverage ratio generally indicates the lowest reasonable cap rate. However, cash flows are generally modified (such as the exclusion of prospective rent). Consequently, this is considered the least reliable methodology (without modification to the cash flow). The parameters used to analyze the subject under this criterion are derived from the other analyses of the overall capitalization rate such as the mortgage constant and loan to value ratio. The debt coverage ratio is generally linked to the loan to value ratio (indicating a ratio of .70 for the subject). Under these parameters, the debt coverage ratio is summarized in Table 3.

It is important to note a downward trend of more than 50 basis points in cap rates over the past two years. This trend indicates investor interest in the self-storage asset class and a willingness in the market to pay a premium. The overall cap-rate analyses and conclusions are summarized in Table 4.

Cap-Rate Conclusion

Typically, market data is emphasized in the conclusion of the cap rate. In this regard, the lag effect common to economics is also common to real estate. In other words, the market (reflected in cap rates) is reacting more slowly than interest rates. Consequently, market data and mathematical techniques must be considered. The selection of the cap rate must be related to the local market conditions (i.e., is the market over-supplied, under-supplied or at equilibrium?) and the subject propertys competitive position in the market area. For the purposes of illustration, a cap rate of 9.0 percent is used in Table 5.

The One True Cap Rate

There is often much discussion about the right cap rate. Borrowers complain appraisers use cap rates that are too high, while banks complain they use cap rates that are too low. In fact, there is not one true cap rate. The data analyzed so far relates to properties operating on a stabilized basis in terms of physical and economic occupancy. However, properties often trade when occupancy is not ideal or stabilized. Watch what happens to our example in Table 5 when occupancy is reduced to 75 percent.

The cap rate declined even as the value declined. It reflects the upside potential in the property because of the vacant area (sometimes this type of investment strategy is called value added). In other words, the buyer can expect a 7.75 percent return on the investment now, but hopes to get a 9 percent return when the property is stabilized. The difference in the value ($4,250,000 to $3,800,000, or $450,000) can be described as absorption costs. Notice, too, the expenses declined in terms of total dollars, but increased as a ratio of the income.

Such transactions are typical to the market. The challenge arises if a 7.75 percent cap rate derived from an as is scenario is inappropriately applied to a stabilized one. The result is a very inflated value scenario. The example illustrates that cap rates must be used reasonably and applied fairly. Citing one example of a cap rate and calling it the market or the one true cap rate for all self-storage properties is a big mistake! As a test of reasonableness, the cap rate is often analyzed in relation to the trailing income, usually in increments of a minimum of three months (latest quarter) and the past 12 months.

Cap-Rate Trends

Interest rates will increase over the next 18 months. This will result in a rise in cap rates, or a decline in returns. As noted in June 19 issue of The Economist, inflationary pressures in the United States include a gross domestic product of 7 percent over the past year, with an inflation rate of approximately 3 percent, suggesting short-term interest rates near 4 percent. In reality, the short-term interest rates are around 1 percent. This gap suggests the supply of available money is too high (or monetary policy supports an inducement to borrowing and spending). Moreover, with a record budget deficit near half a trillion dollars, the fiscal policy means the government is competing with the private sector for the money supply. The tide is rising and interest rates will shortly follow.

Cap rates are highly sensitive to interest rates. As interest rates rise, cap rates do, too. That is only part of the equation, however. Over the past seven years, equity investors have been increasingly interested in self-storage, causing returns to equity to decline (see the band of investment) and putting downward pressure on cap rates.

Therefore, What?

Market conditions, such as oversupply, can cause tremendous upward pressure on cap rates. In this regard, great care must be considered when selecting them. Even in the same city or Metropolitan Statistical Areas, market conditions can vary widely. On the other hand, newer projects with state-of-the-art security and fire/life-safety features tend to trade for a premium, creating a downward pressure on cap rates. Overall, cap rates should be applied only after thorough research that uses several analytical techniques, including survey research, market data and mathematics.

By now, I hope you do not consider cap rates part of an abysmal science. They are an integral component of proper self-storage investment analysis. However, they must be understood correctly and applied properly. A cap rate is a tool and, as with all tasks, the appropriate tool must be used to do the job right.

R. Christian Sonne is principal of Self Storage Economics, a data, research and appraisal firm specializing in the self-storage asset class. For more information, visit www.selfstorageeconomics.com.

Regardless of the weather, the pool is openthe conduit-financing pool, that is. More commercial real estate borrowers are diving into the opportunities offered by conduit financing. With its proven structures and acceptance by the investment community, conduit financing has created a wave of powerful results for borrowers in the form of better terms, more aggressive proceeds and lower interest rates.

This article examines the process involved in pooling conduit loans and turning them into commercial mortgage backed securities (CMBS), with a focus on the role of the rating agency. You will learn about the risks and rewards of CMBS and be in a better position to analyze these financing options for your property. You will also discover the creation of CMBS only begins with the funding of a conduit loan.

Getting Into the Pool

The process of creating a CMBS transaction occurs after the origination of the loan(s) and is seamless to the borrower. Unlike local or regional banks that generally originate individual loans, conduit lenders originate loans for the express purpose of packaging them with other commercial loans of various sizes, property types and locations. Their goal is to ultimately sell the pool of loans as bonds.

To minimize the interest-rate risk associated with having loans on their balance sheet, a CMBS issuer will hold the newly originated conduit loans in its warehouse for only a few months, and will frequently work with other issuers to rapidly achieve the amount of loan collateral necessary to form a pool. On achieving the necessary critical mass, the issuer will transfer ownership of these loans to a legal trust through the use of a unique tax entity known as the Real Estate Mortgage Investment Conduit (REMIC).

As defined by the Tax Reform Act of 1986, REMICs can hold loans secured by real property without specific regulatory, accounting and economic obstacles. Without being taxed at the entity level, REMICs can distribute the cash flow from these loans to bondholders through the issuance of securities. This passive structure is designed to collect principal and interest payments of the pooled mortgages and redistribute proceeds to bondholders.

In the REMIC procedure, the sum of the mortgage pools principal and interest payments (the income stream) are sold as securities. By selling these securitieswhich have been heavily scrutinized and purposefully structured into specific risk classesa market is created to efficiently distribute, price and quantify the risk associated with commercial real estate loans.

CMBS bonds are sold to institutional investors such as pension funds, insurance companies and even banks that originate these types of mortgages themselves. Once the loans are pooled and transformed into risk-adjusted classes of securities, investors view the financial instruments and their expected yield more like bonds than real estate loans.

The end result of this process is a very efficient cost of capital and liquid distribution mechanism for the loan originators. These efficiencies are ultimately returned to the borrower in the form of cheaper capital with better terms than whole loans, albeit with certain restrictions. This is why a property owner should conceptually understand CMBS before diving in.

What are Rating Agencies and What do They do?

Before CMBS transactions are created, there are several steps that must be taken for the newly created securities to be marketed to the investment community. SEC requirements mandate that all public securities must be rated by designated groups that have obtained status as Nationally Recognized Statistical Rating Organizations (NRSRO), better known as the rating agencies.

There are currently four companies in the United States with approved NRSRO designation: Dominion Bond Rating Service, Fitch Ratings, Moodys Investor Service, and Standard & Poors. The rating agencies are a major part of the process of creating new issuance CMBS, and they have a significant influence on CMBS structure and pricing.

Rating agencies examine the aggregate pool of collateral contained in a proposed CMBS issuance and assign risk ratings and subordination levels to the bonds. They rate the bonds from highest to lowest, and according to their loss priority. The ratings assigned to the pool determine its composition and pricing structure, which is then used by the marketing agents to sell the bonds to institutional investors.

Once the rating agencies have assigned ratings to the CMBS issuance, the investors who buy these bonds select their purchases based on the level of credit risk and the yield they desirethe higher the risk, the higher the return. So what are the risks associated with buying CMBS, and how are they quantified by the rating agencies? A more thorough understanding of the ratings process and the structure of a CMBS transaction will help answer that question.

Loan-Level Analysis: Quantitative and Qualitative

Typically, rating agencies will not examine the entire pool of assets, but rather a representative sample, usually 60 percent to 70 percent of the mortgage pool. The sample is purposely chosen to provide the agency with a representative subset of loans by property type, location and balance for each contributor to the transaction.

In conducting quantitative analysis, the agencies re-underwrite the sample to determine an independent estimate of net cash flow for each loan. To accomplish this, each applies its own internal underwriting benchmarks to ensure appropriate credit standards are being met based on its criteria as well as other industry standards.

First, an agency scrutinizes the originators cash-flow projection to ensure underwritten revenue is based on market rents and is not overly aggressive when compared to historical property operations. It also ensures projected expenses and expense ratios are in line with market, historical and actual expenses. The agency then compares net cash flow for a given loan to the originators number to determine if a significant level of variance exists. It will compare the level of variance on the sampled assets by property type and may later haircut the originators cash flow on nonsampled loans within the pool.

Besides cash flow, agencies look at other quantitative loan factors and key indicators, such as loan-to-value ratios, debt-service coverage ratios (DSCR) and borrowers financial strength. In addition, they review all third-party reports used by the originator in making the loan to ensure no exception items are contained. These reports include, but are not limited to, the commercial appraisal, the environmental site assessment and property-condition reports. Additionally, the agencies apply a stabilized market capitalization rate to the adjusted net cash flow to make an independent determination of value.

It is also likely each agency will use its adjusted net cash flow and employ the use of a standardized loan constant (rather than the actual loan constant) to size the loan and determine stressed DSCRs, both at loan origination and the end of the term. A loan constant represents the percentage ratio between the annual debt service and the loan principal (annual debt service divided by the beginning loan balance equals the loan constant). The rationale for this analysis is to size the loan based on normalized interest rates, since interest rates fluctuate greatly over time.

For example, given the same net cash flow, a loan made on an 8 percent interest rate will have a substantially lower DSCR than the same loan made on a 5.5 percent rate. The use of a standardized stress constant allows the analyst and investment community to compare the loan on a relative basis to similar loans made over time. This benchmark analysis ensures debt will be able to refinance in a higher interest-rate environment.

Qualitative factors reviewed by agencies include items such as property location, market, property competition, borrower experience, property age and many others. The rating agencies also conduct physical site inspections of the sampled assets, focusing on the quality and competitiveness of the property in its market, as well as vacant land and new construction that may have a long-term impact on the subject propertys operation.

Structure and Ratings

The CMBS transactions monetary distribution generally follows a sequential payment structure commonly referred to as a waterfall. Each month, the entire sum of all principal and interest received by the trust is collected and redistributed to the bondholders, according to the predefined payment priority. specifically, those investors holding the highest rated bonds (typically AAA) are repaid first and receive principal and interest payments at a priority over lower-rated bonds.

In a typical sequential payment structure, all AAA-rated securities must be repaid in full before any lower-rated bond receives a principal payment. Once all of the accrued interest and principal on the highest-rated bonds have been repaid, principal payments start flowing to the next highest bond holders. This continues in sequence until all of the tranches are repaid, hence the waterfall analogy.

In the event of a default and an associated loss in the underlying mortgage(s), it is likely that there will be a shortfall of principal returned to the structure. In this case, the lowest- rated (or unrated) bond will suffer a loss. If the pool has many losses, the investments of the lowest-rated bondholders will continue to erode. If the losses are significant enough, the entire class of securities may eventually be eliminated, in which case the losses would start to erode the next lowest-rated class. In other words, investment returns are awarded from the top down, and losses are assigned from the bottom up.

Pool Analysis

After completing the loan-level analysis on the pool of assets, the rating agencies conduct a pool-wide analysis to assign subordination levels and determine the ratings allocation for the CMBS issuance. Assigning subordination levels is a complicated process in which the pool of loans is modeled and structured into specific classes of securities, and the risk of credit loss is disproportionately distributed among those classes. The end result is a credit-enhanced, senior-subordinated structure whereby the different classes of bonds carry different risk ratings and repayment terms. To reiterate, the return of principal is typically distributed top down, and losses are allocated bottom up.

The subordination (credit support) for a given class of bonds largely depends on how well protected a particular security is against the anticipated default loss. In general, the lower the credit qualities of the underlying mortgages that comprise the pool, the higher the required levels of credit support at equivalent credit-rating levels. Each of the four major agencies has a different procedure for determining subordination levels, but their end goals are similar as they attempt to model and estimate the credit loss that will potentially occur in the pool over the life of the bonds.

Final ProductRatings and Presale Report

Once all of the analysis is complete and the rating agencies have assigned their respective subordination levels to the pool, they prepare and distribute a document to the investment community known as a presale report. This is a comprehensive document that presents the results of the agencies analysis. Among other things, it will:

• Present the pools composition by property type and geographical dispersion of the collateral.
• Offer a thorough analysis and write up of the pools largest assets by loan balance.
• Disclose any areas of concern or other factors discovered by the agency in conducting its pool analysis.
• Disclose the subordination levels and risk rating assigned to the CMBS, which will be used in the sale of the bonds.

Self-Storage Gets a Lane and Competes Well

CMBS pools contain all types of commercial real estate assets, including industrial, retail, multifamily, office, hotels, manufactured housing, healthcare and self-storage properties. Traditionally, the debt-service coverage stress levels, standardized loan constants and standardized cap rates used for self-storage loans have been more stringent than those applied to other property types.

Self-storage loans tend to have smaller balances compared to other assets, which may mean they are not as well researched and understood by lenders and the investment community. Since a lender does not know which loans are going to be scrutinized by the rating agencies, they underwrite and price self-storage loans in a range they believe will pass the agencies stress levels and internal guidelines and still allow him to make money on execution of the loan sale.

Self-storage loans generally comprise less than 3 percent of the total pool being securitized. According to Citigroup Global Markets, of the total universe of securitized loans, which currently totals around $302.9 billion, self-storage comprises a meager 1.6 percent, or $4.84 billion. Even more astounding is the fact securitized self-storage loans have historically had the lowest overall default rate of all property types: 0.57 percent compared to the average CMBS default rate of 2.4 percent (Rohit Srivastava, MIT Center for Real Estate). Some think this is attributable to the fact self-storage properties have been held to harsher standards than other property types. Proponents believe self-storage properties have historically been over-stressed due to the lack of empirical data available to support the industry.

Regardless, because of its excellent track record, conduit originators have taken note, and self-storage is becoming one of the more favorably priced property types. More than ever, lenders are pushing the stress levels on self-storage loans to new limits with cautious optimism and the hope they will not be negatively affected when the loans are scrutinized. Rating agencies and investors have also demonstrated willingness to listen to the selfstorage story and better understand the nuances of the industry.

CMBS Borrowers Awash in benefits

Over the past decade, CMBS have accounted for an estimated $60 billion annually, and consistently account for a significant component of the commercial real estate debt market. Securitized mortgages constitute the fastest growing category of commercial loans, increasing $15.6 billion in 2003 from the previous year.

The proliferation of the CMBS industry and conduit financing has taken commercial real estate financing to a new level. It has positively affected the capital markets by bringing increased liquidity to lenders and decreasing risk to investors of real estate mortgage debt. They are no longer forced to invest in whole loans, which carry concentrated risk.

CMBS subordination levels have also decreased dramatically in the past 10 years, leading to market entry and fierce competition among originators for conduit-loancollateral. In 1996, average subordination levels for investment-grade bonds BBB or higher was greater than 15 percent. This means a CMBS pool of $100 million dollars was tranched into roughly $85 million of investment-grade bonds and $15 million of below-investment-grade bonds. Today, deals are coming to market at investment-grade subordination levels of 5 percent or less, meaning that of that same $100 million dollar pool, $95 million is investment-grade collateral.

Keep in mind the inverse relationship between risk level and return: the higher-rated (low-risk) classes have lower coupons, and the lower-rated (high-risk) classes have higher coupons. As subordination levels have decreased over time, so too has loan pricing, which is a major benefit for self-storage owners who borrow conduit money. The reasons for these decreases are many, but the main driver is the positive historical CMBS performance.

The CMBS industry is evolving into a major source of financing for commercial real estate property owners, including those in selfstorage. The process of securitizing mortgages into bonds is self-policing and has inherent efficiencies that have been proven as the industry has evolved.

Conduit mortgages are a more practical and viable alternative than even before. As we head toward a potentially rising interest-rate environment, these loans may very well provide the ideal financing terms for self-storage borrowers who wish to finance properties at low rates for an extended period of time. Given these market conditions, expect more owners to jump into the conduit-financing pool and enjoy its benefits in the near future.

Neal Gussis is a principal and Shawn Hill is a vice president at Beacon Realty Capital Inc., a mortgage-banking firm that arranges financing for all types of commercial real estate and specializes in self-storage nationwide. For more information, call 310. 207.0060; visit www.beaconrealtycapital.com.

I recently visited  two self-storage businesses that were similar yet very different. The owners were smart, hard-working and ambitious. The facilities were well-located, and their sizes and pricing equal. And theyd been in business the same length of time. But at one store, most of the units were rented and the owner spoke of opening another facility. The other said business was just OK. He was wondering whether going into self-storage had been a mistake.

There was another fundamental difference: The more successful facility had great retail sales. I mentioned to the struggling owner how nice the office looked at the competing site. He said, Yeah, when Im doing better, I may spruce up my place, too. I suggested that making a good first impression was something that shouldnt be left for later (and assured him I wasnt just trying to sell him merchandise!).

I reminded him that lot of his customers are probably using self-storage for the first time. People feel most comfortable at chain stores, restaurants and gas stations, even if theyre visiting a place thats new to them. Why? Because of the way the place looks. Im no expert on interior design, but I have learned that a neat, bright, store-like setting not only conveys a professional image, it puts customers at ease because it seems familiar.

Show me a Sign

Professional signage also plays an important role. Major retailers use exterior signage to trigger an immediate response in customers. Popular choices are enticements like Back to School Sale and Two-for-One Sale. While many self-storage facilities advertise with signs that read, We Sell Boxes, how many use ones that say, Moving, Shipping and Storage Supplies or Garage Organizer Sale? Signs should promote your products and services in terms of how they relate to consumer use.

Interior signage, on the other hand, is meant to steer sales. Take, for example, signs that persuade you to do something: Super Size It! or Try Our New Desserts. Studies have shown that featured products sell even without sale pricing. Want to sell more than locks? Feature kits with boxes, tape, packing materials and labels for one package price. And the price, mind you, doesnt have to be discounted. It must, however, be well-displayed and properly promoted with signs.

Sign me up

What types of signs look best to you? If youre like most people, hand-written signs (and the products they feature) come across as low-quality. A store dotted with handmade signs looks like a rummage sale; and a self-service business with shabby signage looks unprofessional. To inspire confidence in your customers, follow these simple rules:

1. Convert your office into a store. People are more comfortable in a retail environment than an office, so use your products to create a more familiar atmosphere.
2. Consider your retail products, displays and signage as decor. In the interest of consistency, buy these items from no more than one or two sources.
3. Get free merchandising ideas from your products supplier. The best vendors provide plan-o-grams that identify what to stock and how to arrange it on displays. Do not leave this task to your employees.
4. Use displays and signs that look good together. When in doubt, ask your merchandise supplier.
5. Get the opinion of friends. Ask people who are not in the business to critique your store. It might give you a fresh perspective.

Finally, its hard to convince customers you run a tight ship if your premises are not shipshape. Its just smart business to look every bit as good as you really are. Remember, you only have one chance to make a good first impression.

Roy Katz is president of Supply Side, which distributes packaging as well as moving and storage supplies. The company has developed merchandising programs for many leading companies including Storage USA, the U.S. Postal Service, Kinkos and The UPS Store/Mail Boxes Etc. For more information, call 800.284.7357 or 216.738.1200.

Some salespeople think if they are persuasive and persistent enough, they can get people to give in and buy. But fact of the matter is you cannot sell anyone anything. People make up their own minds. You can put your offer in front of them. You can rattle off features and benefits. You can make it easy to buy. You can even tailor your offering to market research. But when you get to the point of decision, it is the prospect who makes the call. However, you can help him talk himself into the sale. How? Ask the right questions and have confidence in your offer.

The right questions help the prospect sort out all the things to consider and emerge with solutions to problems that involve your service or product. They make it plain to your prospect that buying what you offer is a good idea. Confidence in your offering suggests you have had many happy customers. It tells people you believe your product is a good value for the money. Finally, it means you are not afraid to ask for the business or to approach people who are not yet ready to buy.

Ask Away

Good salespeople ask an initial set of qualifying questions. The answers can tell you where your prospect is in the buying process, what his expectations and requirements are, and what sort of experience he has had with your industry in the past. The next set of questions helps the prospect visualize using your product or service and experiencing the pleasures of ownership.

The right questions help the prospect determine how your offering can be used and how he will see benefit and value. There is an old sales adage that says, If the salesperson says it, it might be hogwash. If the prospect says it, it must be truth. If you tell your prospect he will be happy storing his belongings at your facility, he might not believe you. But if, after some good questions, he tells you he will be satisfied with your service, he will believe it.

One of the most powerful questions to ask is, If you picture putting your belongings in our 10-by-10 or 10-by-15, which one do you think would work better for you? Now, this question involves some setup so it sounds natural and helpful. Many sales closings have been lost by those who didnt use the right line of questioning or wait for the right time to ask. If you master the use of this question, it can be very effective. But remember not to shoot until you see the whites of their eyes.

Close With Confidence

Confidence in your offering comes into play as soon as someone asks, How much is a storage unit? This question translated into real language means Please tell me the value of your facility. If you hesitate when giving the price or sound remotely apologetic, your prospect will get spooked and run. When he responds to your price with a grumble, he is seeing if you think the price is too high. Most people have no idea what storage costs. The best way for a customer to determine if you are overpriced is to suggest that you are and then gauge your reaction. If you are not confident, you will not get the rental.

If the prospect sees that your pricing doesnt make you flinch or quiver, he is likely to agree with it. Use positive phrasing, such as, Our 10-by-10 is only $167, which is a really good rate for the area. This tells your prospect you know prices in the market and yours is not too high for the value. It goes a long way in allowing him to sell himself on your store.

Confidence is also important when explaining your sites features. If you dont express pride in your security and convenience measures, prospects will not realize what makes your facility special. You need them to understand your value and how you differ from competitors. You want them to think, Well, it sounds like this place has got everything I might need, and the rent isnt too bad, either. After that, its easy for them to conclude, Ah, I might as well just rent here.

Dont sell. Be aware of your prospects thought processes. Help them talk themselves into renting from you. Ask good questions and have confidence in your store. Then simply ask, Which day would you like to move in? Good luck and good selling.

Tron Jordheim is the director of PhoneSmart, which serves the self-storage industry as an off-site sales force that turns missed calls into rentals. This rollover-call service serves as a backup to store managers. Mr. Jordheim has started several successful businesses from scratch and assisted with acquisitions as general manager of the Mid-Missouri Culligan Bottled Water franchise. For more information call 866.639.1715;
e-mail [email protected].

Judging from the following data, whats selling is just about every type of self-storage facility, from those with less than 5,000 square feet to others with 350,000 square feet. They range in age from new to more than 30 years old. Some sales involve converted industrial buildings of more than 50 years old. As to who is buying, the answer is anyone who can find a facility to acquire. Investment demand has never been greater.

This article looks at data from 195 self-storage facilities that transferred ownership between January 2003 and April 2004. For the most part, they were single-property acquisitions by individuals and some major players, including institutional investors and REITs. I selected facility data randomly from publicly available sources. I have not personally verified the numbers, but the publishing source has reportedly confirmed the facts with the buyers, sellers or brokers involved. As the map shows, the sales occurred in major markets across the country. As the data demonstrates, you cannot listen to or rely on a single source for answers to questions like What is the current cap rate?, How much are people paying? and What markets are hot and which are not?

Capitalization Rates

One of the more interesting bits of information to be found in any sale is the capitalization rate, or cap rate. Unfortunately, due to the difficulty in obtaining the data to calculate cap rates, they are seldom reported. In my sample, only 38 of the 195 transfers (19 percent) reported a cap rate. Those rates ranged from 5.26 percent to 12.70 percent, and the average was 9.14 percent (the median was 9.00 percent). This range represented cap rates based on the trailing net income as well as the buyers pro forma income. Therefore, the average or median disclosed from the data is misleading and of little help in determining the cap rate for any particular facility.

You can follow the trends and talk to the experts, but the truth is, selecting the proper cap rate to reflect the risk of a property is difficult. The reason is simple: There are numerous variables; reporting is inconsistent; and methodology for calculating the rate is different and usually does not disclose the investors motivation.

Most major investors require brokers to sign confidentiality statements, which prohibit them from disclosing the purchase price or net operating income, so calculating the cap rate is not possible. Therefore, unless you have access to the actual data, what is available from the marketplace usually involves someones opinion, which is not very solid ground on which to determine value. Investors should always check the price they agreed to pay (based on a cap rate) to see how it compares to the facilitys replacement cost.

Sale Price per Square Foot

While everyone is quick to agree the cost approach is not an appropriate method to value existing self-storage facilities, check out the premium some investors are paying over replacement costs. Twenty-two percent of the investors paid more than $75 per square foot. In most instances, they will tell you there are barriers to entry, meaning it is very difficult to find land to develop, the entitlement process is expensive, or no existing buildings are suitable for conversion. The following chart illustrates the prices paid per square foot of net rentable area of my sample.

Assessed Value per Square Foot

Another interesting facet of this analysis was the range of assessed value per square foot of facilities at the time they transferred. Keep in mind many taxing jurisdictions trigger a reassessment upon transfer. Therefore, the risk of real estate taxes going up should be reflected in the cap rate.

For instance, if two identical facilities were offered for sale but one was subject to a tax reassessment upon transfer, would you be willing to pay the same price for both? Of course not. With all else being equal, you would pay less for the one subject to the possible tax increase. Therefore, the cap rate on the one facility would be much higher to reflect the risk of increased expense. There are operators who purchase facilities not knowing taxes will increase and, as a result, their returns are marginal.

Facility Age

Ever wonder how much the age of a facility impacts its selling price? In our sample, age had very little effect (see the following scatter diagram). When comparing the age of the facility to the price paid per square foot, there was no statistical correlation, meaning age alone did not impact how much someone was willing to pay. That makes sense, given that tenants in older buildings typically paid the same rent as tenants in newer buildings.

In the diagram, each dot represents an actual sale. Thus, a facility that was only 1 year old (red dot) sold for slightly less than $20 per square foot. Another facility that was 50 years old sold for more than $120 per square foot (yellow dot). All else being equal, age does not have an impact on price.

Market Summary

Some interesting statistics emerge when studying individual markets, particularly when paying attention to the cap rates in a given area relative to the purchase price per square foot. As noted earlier, very few sales report the cap rate. In the markets represented on the following chart, only 27 of the 116 sales (23 percent) included cap-rate information. Other sales in these same markets demonstrate a wider range of cap rates, so unless you have access to a larger sample of sales, you could be misled. The sampling shown is too small to draw any meaningful conclusions, but is intended to demonstrate the wide range in various markets. (See the table below.)

An investor buying a portfolio of facilities in each of these markets would probably base the purchase price on a cap rate below the lowest of the rates demonstrated here. This just points out the importance of knowing not only your local market conditions and whether your facility is investment-grade, but also who the buyer would be before you can determine the proper cap rate.

click here to view table

Conclusions

It is not easy to determine the proper cap rate for a specific facility. Cap rates on individual properties vary by market, given local conditions. Rates on portfolios, however, are generally the same, given geographic diversity. Investors, who buy portfolios of several facilities at a time, take the strong performing facilities along with weaker ones at the same cap rate.

With the intensity of self-storage development, the determination of future risk is made even more difficult by unknowns in future tenant demand. Investors should put less weight on cap rates, given the variables involved in their calculation and the inconsistency in how rates are reported, and give more consideration to the price paid per square foot.

There are two cap rates for each transaction. One is based on a facilitys trailing 12 months of net operating income. The other is based on the buyers pro forma net operating income. For investment-grade facilities, there are two distinct buyers, individuals and major players, both having different motivations.

Charles Ray Wilson is President of Charles R. Wilson & Associates Inc., which specializes in the valuation of self-storage nationwide. Mr. Wilson also owns Self Storage Data Services Inc., a research firm. Both companies are based in Pasadena, Calif. For more information, call 626.792.2107; e-mail [email protected].