“The self-storage industry is at a crossroad as it travels down the path to maturity.” Ray Wilson, Self Storage Data Service Inc.
The above quote from Ray Wilson could well be describing America, for there’s no doubt we, as a country, are at a crossroads—from the wars overseas to the financial one everyday Americans are fighting at home. At the time of this writing in December, a new president had been chosen, but had yet to take office. Automakers were failing, as were lending institutions. Foreclosure and unemployment rates were at an all-time high, while the availability of credit was nearly impossible to find.
Although the economy was feeling the affects of the recession since the beginning of 2008, it wasn’t until Dec. 1 that it was officially declared a recession. Now, some economists are predicting we’re in the worst recession since 1981-82.
For self-storage owners, developers, builders and investors, there’s no doubt that 2008 was a bumpy year. For many, it was a year of losses and slowdown; others fared better. “The self-storage industry is enduring arguably one of the toughest economic environments it has ever experienced,” says Minh Tran, managing director, Holliday Fenoglio Fowler LP in Houston. “Consumer confidence is at an all-time low; unemployment rates are continually on the rise; and many have lost a considerable amount of money in the stock market.”
Now, with a new president in charge and promising a revived economy, everyone is hoping 2009 will be the turnaround year.
Basic Supply and Demand
While the self-storage industry has always been touted as recession-proof or, at the very least, recession-resistant, it was put to the test in 2008. Across the country, self-storage builders and developers saw projects disappear as banks tightened lending and raw materials drove up the cost of construction. Likewise, investors and self-storage owners scrambled to find suitable loans. Some facilities reaped the benefits as foreclosures forced people from their homes. Others saw rent increases and new rentals drop at alarming rates. And many facilities grappled with tenant delinquencies or those who simply walked away because they could no longer pay for their units.
“The belief that self-storage was recession-resistant was based upon its performance in earlier recessions when the industry was still building to a huge pent-up demand,” Wilson explains. “The demand was so great that changes in the economy did not affect the self-storage owner’s ability to increase rent and still maintain physical occupancy.”
Now the balance between supply and demand has tipped the scales in the other direction, Wilson says. “The current level of supply of space has satisfied the pent-up demand and now changes in the economy do impact performance.” However, he does maintain that the self-storage industry is not as sensitive to downturns in the economy as other real estate sectors, such as hotels or retail. “There is that segment of storage demand that comes from ‘need’ resulting from disruptions in people’s lives, which helps balance performance during these turbulent times.”
How a facility faired in ’08 depended largely on the market in which it resided. Markets with heavy foreclosures enjoyed increased occupancies, while other markets had more empty units. “Although we have seen reductions in overall occupancy, a drop off in telephone-call volume and walk-in rental traffic, and increase in the traditional levels of delinquencies, our occupancies on a relative basis are still OK,” notes Jim Chiswell, industry consultant and owner of Chiswell and Associates LLC in Palmyra, Va.
Some facilities experimented with concessions; others conducted exit interviews to pinpoint why they were losing tenants. “People are making very conscious budgetary decisions,” Chiswell says. “For the most part, the purchase of our product is a discretionary expense.”
The Construction Slowdown
One segment of the self-storage industry hit the hardest was the construction of new facilities. The sudden spike in raw material costs—most notably steel—in the first six months of 2008 greatly affected new self-storage construction. “By July, steel escalated to almost 48 percent above pricing at the turn of the year,” notes Chip Cordes, vice president of U.S. Door and Building Components, Orlando, Fla. “Many projects experienced 10 percent to 20 percent increases; however, the total cost of most projects was not as drastic as what was expected.”
As the cost of steel rose, many projects already underway were suddenly under-budgeted. And with the tightening financial market, some developers struggled to keep their projects afloat. Plans for new facilities were put on hold or even scrapped entirely as construction costs soared and financing dried up. “There’s no doubt that the 2008 economy has had a negative affect on new self-storage construction,” says Caesar Wright, president of Mako Steel Inc., Carlsbad, Calif. The rise in raw materials coupled with a soft market made it difficult to find good loans. “In my 20 years in this industry, I’ve never seen anything like it,” Wright says.
The weak economy and lack of good financing “shut down” most new construction, notes Mike Parham, president of The Parham Group in Bulverde, Texas. “In the Southeast and Southwest markets we have been developing in for the last several years, construction has been limited to projects that started before the stock market’s volatility. The whole self-storage development cycle has shut down.”
Despite the lack of good financing from traditional lending sources, there are still a large number of new construction projects in the works. “I continue to work with clients who have identified excellent sites and have established banking relationships that make financing a non-issue for them,” Chiswell says. “The marginal developer who had been relying on finding a silent partner investor, along with high leverage on a cost-to-loan basis, has been almost totally eliminated from the game for now.”
“It’s extremely tough out there,” adds Buster Owens, president, Rabco Corp. in Winter Garden, Fla. “The bright side is that these escalating steel prices and other things we’ve seen over the last couple of years are on the way down, so marginal products are starting to fall back in line with the pro formas. There are still people out there that have access to financing, but it’s tougher now than it has been in the past.”
To stay in the game, some construction companies are turning to conversions and facility remodeling. “Our industry is starting to age,” Owens points out. “There are more 20-year-old buildings; some need facelifts or a new roof. Some of the big guys are taking time to enhance existing facilities by expansion or building a multi-story.”
And as steel and other costs—including crude oil—continue to drop, most remain positive that new construction will ramp up again. “As we recover from this economic slowdown, the population will once again purchase goods and store goods,” Cordes says. “Self-storage will become an important part of this trending cycle.”
The Search for Financing
When the housing crisis hit last year, it was unclear just how far it would reach. Ultimately, it would have a ripple affect. “The residential exposure caused more than 20 banks to fail in 2008, and many more to be considered ‘in trouble,’” Tran says.
With the failure of America’s financial institutions came fewer available loans and tightened underwriting standards. Suddenly, developers and investors, along with owners looking to refinance their existing loans, had a harder time finding financing. “Owners of stabilized properties in the self-storage sector were able to obtain very favorable terms in the past through the commercial mortgage-backed securities (CMBS) market,” says Eric Snyder, senior vice president, Buchanan Street Partners in Newport Beach, Calif. In fact, the CMBS market accounted for $224 billion in financing for all commercial real estate asset types in 2007, and provided self-storage owners with 80 percent non-recourse, 10-year fixed-rate loans in the 5 to 6 percent range, according to Snyder.
With CMBS lending gone, local and regional banks supplied some capital, as did life insurance companies and pension funds. “At the end of the day, a self-storage owner has fewer options available than he did just 12 months ago,” Snyder says.
Today’s highly conservative lending environment is what is known as a “flight to quality,” says Neal Gussis, principal for Chicago-based Beacon Realty Capital. “Quality” is a combination of a property’s physical attributes and condition, location and historic performance, among other factors, Gussis says. “When underwriting a transaction today, lenders are likely to examine a longer historic period, as well as the micro and macro markets for trends and comparables.”
Financing terms have also shifted dramatically because lenders want more equity, according to Gussis, with lending programs not exceeding 70 percent of a property’s value, compared to 85 percent—or even 90 percent in some cases—in the previous years. “This has been a double whammy since cap rates for most properties have widened by at least 50 basis points.”
While financing is harder to come by, it is still available. “But loans are not plentiful and carry shorter fixed-rate terms and amortizations, more rigid underwriting and higher rates than in the previous five to six years,” says David Smyle, president of Benchmark Financial, La Mesa, Calif. “Lenders are very picky about the occupancy, borrower financial strength and experience, and property quality.”
Investors also need to recognize that today’s real estate investments are valued on generated income rather than potential income. “A property’s location must be able to stand the test of time,” Gussis says. “Owners will need to exercise more patience and create value over time by managing revenue and expenses. Making the right investment will also entail obtaining leverage that provides some room to ride out the economy ... most likely a loan that matures in no fewer than three years.”
In today’s recessionary environment, self-storage owners need to be “smarter than ever to manage rents, operating expenses and occupancy levels,” Gussis says. The key to a facility’s operational success is to provide customers with a range of price points and related amenities within their disposable thresholds, he adds. “Whether they want or need to rent a storage unit, most customers these days are highly price conscious. Creative marketing techniques can help attract the attention of potential customers looking for rental bargains.”
At the time of this writing, Congress was still working out the kinks in the billion-dollar bailout to soften the blow of the failing U.S. economy. “The bailout should have a good affect on the storage industry on a long-term basis,” Tran says. “The Treasury is trying to do everything they can to address falling home prices and mounting disclosures. Whether people are downsizing, buying or moving, storage is a good solution for them.”
“Any housing-market jumpstart will also inspire greater confidence in consumers to spend money and ultimately use storage products,” Gussis adds.
Real Estate Stalls
The unstable financial market has also greatly affected the commercial real estate market. The real estate investment trust (REIT) market was poised for big losses in 2008. The industrial sector was down 81.11 percent, lodging and resorts 66.57 percent, and regional shipping malls 66.34 percent, according to the Association of Real Estate Investment Trusts. In comparison, the self-storage industry performed the best: dropping only 14.59 percent last year.
Although self-storage fared better than many other types of commercial real estate, there has been a slowdown in acquisitions. “Deals are still being done, but not at the same pace as before,” Wilson says. In addition, properties are sitting on the market longer. “Values are now down at least 20 percent and I won’t mention equity erosion—all this without changes in net operating income,” says Michael McCune, president of the Argus Self-Storage Sales Network, Aurora, Colo. The average property value is down 20 to 25 percent, predicts McCune. “The net result is that buyers can’t find loans that work at the 2007 values.”
In addition, many sellers have unrealistic expectations based on a “precedent set by a few buyers in the market that spent acquisition money like drunken sailors, without exercising proper due diligence, or in some cases, common sense,” says RK Kliebenstein, owner of Coast-to-Coast Storage, Atlantis, Fla. “When those deals go sour—and they will—that will make it tough for others to get easy access to financing.”
Falling equity has also has led to a large spread between the “bid” and the “asking price,” Wilson notes. “But that will change when many of the investors who entered the market most recently realize they are locked into a low-yielding investment with little upside, and they decide to cut their losses when their loans start coming due,” Wilson says.
For those looking to purchase an existing facility, due diligence is the key to ensuring it’s the right investment. “An investor must do a serious, professional demand study,” McCune says. “Know all the details of every competitor within five miles and compare them to the proposed purchase, understand the property and be aware of the cap rates in the area.”
Looking Ahead
Without a crystal ball, it’s impossible to predict what the future holds for the self-storage industry in the coming months. As the U.S. government attempts to untangle the housing mess and financial crisis, many self-storage owners, developers and investors are left on the sidelines ... waiting. “Owners and investors alike need to understand that the capital markets look completely different than they have over the last few years and may continue to get worse before it gets better,” Tran warns.
That means fewer loans with tighter restrictions, which could leave some industry people out in the cold. “The developers with good credit, strong net worth and income, and that have a track record in self-storage will have access to capital; others will not find it so easy,” Kliebenstein says. “Projects are going to have to stand on their own merit. Gone for a while are the ‘lend on blue sky’ days.” Kliebenstein also believes occupancy levels will continue to slide, and rate increases will be nominal until the real estate market returns to a healthy state.
Essentially, expect rougher waters ahead, Smyle says. “Most of the financing will be done by local and regional banks but expect tighter underwriting, higher down payments on purchases, more scrutiny and seasoning on cash out, more emphasis on borrower financial strength and income, and higher rates than seen in previous years on fixed-rate product.”
However, the slowdown in new facility construction and tighter loan conditions could have a silver lining for self-storage owners in crowded markets. “It’s simple math,” McCune says. “Self-storage space is growing at a faster pace than the population.” With national average occupancies hovering around 80 percent, the industry, for the most part, is meeting the demand, he says. “You must always watch out for overbuilding in your market, it is the Achilles’ heel of self-storage when demand is even somewhat limited.”
While there is still uncertainty about the economy and what the future holds, most people in the industry remain positive about the future of self-storage and the integral role it plays in American society. “The storage industry has proven its long-term viability by attracting a large and diverse base of customers,” Gussis says. “It will be the self-storage community’s job to continue to capture and fulfill their needs with outstanding products that are priced appropriately given current market conditions.”