ANYONE WHO BOUGHT A SELF-STORAGE FACILITY AT A LOW CAP RATE IS IN BIG TROUBLE By Frank Rolfe

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We all heard about self-storage buyers who would buy properties in major markets at low cap rates in recent years – often at cap rates just slightly above interest rates. 4% was a common theme, and that was based on a 3.75% mortgage. But those same buyers are in big trouble right now, and will likely either lose their properties in the years ahead or never hit any type of meaningful return on investment.

How this happened

Large corporate self-storage investors became too zealous during the period following the 2007/2008 Great Recession and massive amounts of capital poured into the pockets of those who aggressively bought properties at insanely low cap rates of around 4%. They argued that these buys were still profitable thanks to fixed interest rates around 3% on 10-year terms. However, those loans are now nearing expiration, and when interest rates re-set they will render the properties insolvent, as interest rates on self-storage have roughly doubled while net income has not gone up at all. That means that 4% cap rate storage properties now will face 6% interest rates, negative cash flow, and a valuation that is upside down. And that spells disaster. To even make matters worse, the self-storage industry added another 16% of supply in the past three years, virtually all of which are in big urban markets.

How to harness their misfortune for your gain

The sudden erosion in values for those big, urban storage properties owned by the largest corporate owners is their misfortune and here are the likely results:

  • Competition will be reduced as the major players attempt to clean up their mess. Most of the larger storage owners will have a lot of work to do to try to reorganize their debts to remain in business. This will halt their new acquisition efforts and reduce competition for properties.
  • New building will come to a standstill. There were around 256 million square feet of new self-storage facilities built in the U.S. within the past few years. That’s bad from a supply/demand standpoint. However, that will now end as nobody is going build new storage when they have bigger problems to deal with, and the majority of this storage space was built by the largest owners.
  • Properties will start coming up at auction from lenders. When a borrower defaults on their loan, the lender frequently takes that property to auction. And there can be some good buys to be found at those auctions.

The lessons learned (just as always)

The self-storage industry has been through this chapter before. Many of the high-flying storage owners of the 2000 to 2006 era crashed and burned in 2007/2008 and after. And that’s exactly what is happening again this cycle. What should have been the lessons learned last time, and is reinforced now?

  • You have to maintain a healthy spread between the loan interest rate and the cap rate. You cannot make money with any storage facility if the interest rate on the loan equates to – or exceeds – the cap rate. Buyers should have never let themselves fall into that trap again.
  • You need to have a plan to increase the net income to build a safety buffer. The worst thing you can do if you buy a property that has a very small difference between the interest rate and cap rate is to buy storage facilities that have very little room to increase the net income with rent or occupancy increases.
  • Overbuilding has always been a risk. One of the biggest issues in the storage industry has been its penchant to overbuild. These cycles are total predictable, and when that new 256 million square feet of storage started popping up, the smart investors should have hit the brakes on buying at such high prices.

Where the new opportunities are now

The big urban sector of the self-storage industry is so screwed up right now that it will take years to correct. But that’s OK because the real opportunity in self-storage is found in new areas:

  • Suburban and exurban locations. These are storage facilities that are just beyond the typical urban boundaries – an area ignored by big players in the past. With Covid-19 and the riots of 2020 came an exodus from the urban core to the safer and less dense suburban and exurban areas. This is where most people are moving and that’s where the demand is going.
  • Old fashioned one-story with roll-up doors. Suburban and exurban markets are traditionally build in the absence of multi-story and climate control – and that’s a much simpler business model to fill and operate.
  • Mom and pop sellers with plenty of meat on the bone. When you buy properties in suburban and exurban markets you are always buying from original moms and pops. These are great people who negotiate a fair price, often include seller financing, and have properties that you can easily improve the net income on through internet marketing, raising rents and cutting costs.

Conclusion

Big players made some terrible mistakes over the past few years. While they are stuck in the mud, it’s a great opportunity to buy what’s in demand now, which are original suburb and exurban properties where there’s money to be made.

 

BY Frank Rolfe  has been an active self-storage investor for around two decades, with self-storage units in many states throughout the U.S. His nuts and bolts knowledge of what makes for a successful self-storage facility has led to a three-decade career without a single failed property.