Author : Faizan Athar
It’s hard not to love the real estate niche of self-storage. The sector offers investors a high potential for upside, does well in economic booms and busts, generates high free-cash-flow, requires low capex, and can operate with minimal oversight. Self-storage facilities are characterized by low overheads, minimal construction costs, month-to-month leases, and sticky tenants. If you want to invest in self-storage, there are two ways you can go: passive or active. If you want to be a passive investor, the best way to do so is to buy shares in publicly traded companies operating in the self-storage industry. If you want to be an active investor, you can buy an existing facility or build a new one. This article is geared towards those who want to be directly involved in the ownership and/or operation of a self-storage facility.
The self-storage industry generates approximately $39 billion in annual revenue. Estimates put the number of self-storage facilities in the country between 45,000 to 60,000 (depending on how a self-storage facility is defined and the methodology used), which translates to 1.7 billion square feet of rentable self-storage space. The industry is considerably fragmented; according to RealtyMogul, “the top 10 operators control approximately 16% of the facilities, the next 11-50 operators control approximately 6.5% of the facilities and with the remaining approximately 77% of the facilities controlled by independent owners”.
Because the industry is heavily fragmented, a savvy investor may find it worth their while to buy a mom-and-pop facility, turn it around and increase profits, and then enjoy the income or sell to a real estate investment trust (REIT) or institutional investor. This takes advantage of what is known as a consolidation play, where a handful of market participants initiate aggressive acquisition strategies in order to gain market share.
There is no denying that the market for self-storage is more competitive than ever. Gone are the days when an advertisement in the yellow pages would have sufficed. Most customers find storage facilities by searching for them on the internet. A small, independently owned facility will be no match for a large player’s marketing prowess, including the all-important Search Engine Optimization techniques that allow a facility to rank on the first page of websites like Google. Marketplaces for self-storage, such as SpareFoot, are helping level the playing field, by providing a platform for smaller facilities to reach their customers for a fee. The built-in downside is that such platforms will also be providing visibility to any independently owned facilities that compete with your own. Increasingly, rentals are occurring through mobile devices, which has made it important to engage in local SEO and to make sure your business is listed on Google Maps.
This article lays out the factors that influence the decision to underwrite a self-storage facility; naturally, these factors aim to maximize the return from an investment, while minimizing the risk. If you’re in the market to purchase an existing self-storage facility or want to build your own from the ground up, taking these considerations into account can be the difference between outsized profits and failed investment.
According to Pinnacle Storage Properties, “underwriting is the process used to determine the financial feasibility of an event such as the acquisition, refinance, recapitalization, construction, or expansion of a property”. There are three main stakeholders involved in an underwriting deal: operators, lenders, and investors. Although the aims of each class of stakeholders are distinct, they are aligned; they all benefit from the financial viability of the storage facility. Operators use market data and their experience in the industry to build value into the facility; their experience enables them to decide what capital improvements and management restructuring are necessary. Lenders are primarily concerned with the borrower’s ability to pay back their loan; they look at metrics such as the debt-service coverage ratio (often establishing minimums) to identify whether the income from the proposed project will be sufficient to cover interest and principal payments. Investors want competitive returns; they may look at metrics such as the equity multiple or IRR (internal rate of return) to monitor how well their investment is doing.
The number of units currently occupied by customers, as a percentage of total units available for rent.
Economic occupancy refers to the amount of rent collected as a percentage of asking or gross rent. Another way to understand the concept of economic occupancy is to think of it as the amount of rent successfully collected as a percentage of the amount of that could potentially have been collected. Economic occupancy may be impacted by factors such as the number of vacant units, outstanding rent payments, and discounts — anything that can increase the gap between actual and potential rental revenue.
A property is said to have stabilized if it achieves 80-90% economic occupancy for 12 months.
The lease-up schedule refers to the time taken for newly available properties to attract tenants and reach stabilized occupancy. Typically, the time taken for self-storage facilities to stabilize is three to four years.
Net Operating Income is defined as gross income, less operating expenses.
According to Investopedia, “the debt-service coverage ratio (DSCR) is a measurement of the firm’s available cash flow to pay current debt obligations”. The debt-service coverage ratio is calculated by taking the net operating income and dividing it by the total debt service over the same period. A ratio greater than one indicates a positive cash-flow, while a ratio of less than one implies that the business is generating less income than it pays out to its creditors. Lenders look at the DSCR to evaluate the creditworthiness of loan applicants.
The capitalization rate is defined as the initial yield on a real estate investment. It is calculated by taking the NOI during the first year and dividing that by the cost of acquiring the facility or, in the case of a new facility, the expected total development cost. The cap rate gives an investor a sense of the return they are getting on their investment; a 10% cap rate implies that the investor receives 10 dollars of income for every 100 dollars invested. Because of their reliance on the value of income, cap rates are most useful when calculated for stabilized assets. If you are interested in an under-performing facility that has the potential to be turned around, you can use the market cap rate suggested by previous sales of similar facilities to get an idea of what the facility will be worth once the income stabilizes. Alternatively, you could calculate a cap rate based on stabilized future NOI.
It’s a cliché because it's true; the value of real-estate is inextricably tied to where it is located. Ideally, you want to buy (or build) in an area that has high demand, but low supply. That may seem like a no-brainer, but as with most things, the devil is in the details. Before we talk about demand and supply factors, we need to define the trade area for the facility. You can think of the trade area as a circle containing your most likely customers, with you at the center. The size of your trade area will vary based on where you are located. Suburban properties tend to have a trade area of 3 miles, a rural property may have a trade area of 5 or 10 miles, whereas dense urban areas like Manhattan may have trade areas of less than a mile. As a general rule of thumb, you want at least 50,000 people in your trade area. A drive-time of 5-10 minutes on Google Maps can give you a good idea of how far your trade area extends.
Firstly, you want to look at the number of people living in your trade area. This takes into account the fact that most consumers would prefer to have easy and convenient access to their unit, without having to drive too far. It’s a numbers game; the more people that live close to your facility, the higher your potential customer base. Growth trends are also pertinent, as they have a bearing on the future demand for the storage units in your facility. Look for areas that have a steadily upward trending growth in population over the last 5-10 years. The U.S. Census Bureau offers population estimate data down to the county level, including numeric and percentage growth.
Secondly, you should look at the median income of households located in your trade area. A higher median income means that more households have the means to rent storage space. The median income may also allow you to understand the needs of your potential customers. On a related note, also look at the job growth in the area you plan to operate your facility in. Strong growth in jobs bodes well for demand. The Census Bureau offers data on median income at the county level, up to 2018. If you want more granular data, Income By Zip Code offers median income data at the zip code level.
Additionally, you can look at the percentage of households occupied by renters, as opposed to homeowners. The idea is that areas with high residential turnover will provide the facility with steady demand for its units. This is a big reason why facilities located near military bases and college campuses tend to do well. Governing.com is a good resource for obtaining renter population data by city. The number of vacant housing units is also pertinent, but the reason for their vacancy deserves some attention. Vacancies may be an indicator of future moving activity, which could drive demand for self-storage. However, if the number of vacant housing units has been on the rise due to net outward migration, that could be a cause for concern.
An understanding of the movement of housing prices in the trade area can be helpful as an indicator of household wealth; the Housing Price Index released by the Federal Housing Finance Agency is a good place to look for trends in the prices of residential real estate.
The average size of a house in the area you are interested in is also a relevant metric to look at. The smaller the average house is, the better; households will have less space for their storage needs, creating demand for your storage units.
You might also want to look at the number of businesses that are located near your facility. Businesses are increasingly becoming important clients for the self-storage industry, and typically prefer units on the larger side for their storage needs. The Census Bureau offers Zip Codes Business Patterns data that may be of use.
Demand, however, is only one side of the story; there are also supply factors to consider. When considering supply, there are a couple of things you should keep in mind. When looking at the competition, you should consider the quality and quantity of competitor facilities.
As far as quality is concerned, it is easier to compete with small-scale owner/operators rather than Real Estate Investment Trusts (REITs) with deep pockets. REITs have superior management experience, sophisticated technology, and the capital required to sacrifice profits for market share.
With regards to quantity, you want to look at the number of self-storage facilities located within the trade area of your facility. The lower, the better; the general rule is that there should be less than 5.5 square feet of mini storage per person in a given market. You should also consider the distance to the closest competing facility. The higher the distance between your facility and that of a competitor’s, the better, since consumers will typically choose the facility that is closer to their place of residence.
There are three classes of facilities: Class A, Class B, and Class C. Class A facilities command the highest rents; they have superior locations and access, high-quality construction, on-site management, higher standard of maintenance and security, and usually offer climate-controlled units as part of their unit mix. Class B facilities are a rung lower on the quality ladder, and as a result command lower rents than Class A facilities. Class B Facilities may have on-site or off-site management. Finally, Class C facilities have the lowest asking rents, as a result of their location, limited access/curb appeal, a fair amount of deferred maintenance, minimal/no security, and usually do not have an on-site manager.
You should look at factors like the condition of storage-unit doors, any water or fire damage, and the state of HVAC units for climate-controlled units. If the facility you are interested in is a drive-up or offers vehicle storage, you should examine the asphalt and look for any potholes that might need repairing. In a nutshell, look for any significant deferred maintenance and factor that into the calculation for the value of the facility. You should also look for anything that may be a source of liability under environmental laws, such as asbestos, mold, lead-based paint, petroleum products, etc. Your lender may require a Phase I Environmental Site Assessment as part of the lending agreement, which covers some sources of liability.
Examine the security arrangements at the facility, and evaluate their appropriateness with regard to the size of the facility, clientele, and the area in which it is located. Check to see if there is a security guard or team, the number and positioning of security cameras, individual alarm systems that detect unauthorized access to units, perimeter fencing, on-site management, and barrier arms. Most facilities now have coded gates, which are more secure than locks. The fire protection system should be up-to-code.
In order to spread out fixed costs such as on-site management expenses, it makes greater economic sense to have more than 50,000 square feet of leasable area (1, 2). The facility should be large enough to justify an on-site office and apartment (in case the manager lives on-site).
If you are evaluating an existing facility, check to see if it complies with the local zoning laws. If you are looking to develop a facility from the ground up, you should brush up on the zoning laws in the city you want to locate your facility in. Land with permitted use does not require approval, and the building of a storage facility on that land is allowed so long as it complies with development standards. However, most cities have placed self-storage in the conditional use category, which usually requires public hearings before approval is granted. This makes zoning one of the biggest challenges faced by those who wish to develop facilities from the ground up, as it can be difficult to obtain the necessary approvals. There is potential for the project to be politicized by interest groups; however, taking stakeholders on board and educating the local populace about the benefits of a storage facility can be helpful. On the bright side, if you manage to get approval in an area with strict zoning processes, they can act as a barrier to entry, thus limiting future supply.
Considerable landscaping may be required to appease zoning officials and local interest groups, who might be concerned about the appearance of the facility and how that would impact the aesthetic feel of the area. However, the landscaping would also make your facility more attractive to potential customers, so it might end up paying for itself. Ideally, the facility should have an on-street location, with significant traffic volume (foot-traffic if in a dense urban location). Make sure that the facility has adequate lighting.
When determining the price of a facility, appraisers generally look at any sales of similar facilities that have occurred over the last 6-9 months within the same geographic location. An existing facility’s operating numbers come into play in determining the market price of a facility (recall that market price is equal to Net Operating Income divided by the Cap Rate). While calculating income, the items included are rent, fees, and goods sold. Consider which revenue streams will transfer once the facility changes hands; will you keep the truck rental business, or receive payment for any billboards on your property? Factor these into your calculation for income. Expense items include real estate taxes, insurance, third-party management, office, salaries, repairs & maintenance, advertising, utilities, and miscellaneous. Some of the items under the expenses header might look different if you end up purchasing the facility; the purchase price will likely trigger a new real estate tax assessment, the current owner may be running personal expenses through the facility’s books, and so on; adjust expenses to what they are likely to be post-acquisition. If the current owner did not retain the services of a third-party management provider, it is standard to add five percent of gross income to expenses to reflect this cost. Industry standards set minimums that also have to be met with regard to other expense items, such as advertising. Look at historical financial documents to get a sense of the trend displayed by Net Operating Income. If it’s been increasing over the past couple of years, that’s a positive. If it’s been decreasing, however, try to understand why; is it because of inefficient management, or broader market conditions? Once you have a figure for Net Operating Income that appropriately reflects the facility’s income potential, all that’s left is for you to obtain a realistic cap rate and you’ll have a number for the valuation of the facility. As stated above, past facility sales in the area can be a good indicator of prevalent cap rates; real estate brokers specializing in self-storage are a good resource in this regard. Generally speaking, buyers tend to overestimate cap rates, while sellers may underestimate them. It’s important to recognize that a deal may only be finalized when the buyer and seller’s opinions on the value of the facility converge.
The most common financing options for self-storage include conventional bank loans, SBA 7(a) loans, and SBA 504 loans. Financing may be obtained for purchasing a facility, building a new one, renovating an existing facility, or refinancing a previous loan.
Qualification requirements may vary by lender, project, and type of loan, but typical requirements include a minimum credit score of 680, more than 2 years in business, a DSCR of 1.25x or greater, and reasonably good credit history.
Conventional bank loans require a high amount of equity (typically 25-35 percent). This means that, of the total amount required, the borrower will have to put up 25 to 35 percent from their own pocket. Conventional bank loans usually have relatively short terms, which means that you will likely have to refinance at some point. Conventional bank loans may also have Loan-to-Value (LTV) covenants, financial covenants, and DSCR covenants; non-compliance with these covenants will be treated as defaults, as they are designed to limit the bank’s risk. Focus on the terms of the loan beyond just the interest rates, such as whether there will be a balloon payment, if there are any prepayment penalties, etc.
The SBA does not lend money, but it does guarantee a certain portion of the loan amount, which allows borrowers to take out a loan while putting up less equity than they would have to with a conventional bank loan. The minimum equity requirement for the 7(a) loan is 10%. There are typically no covenants, except for the borrower to be timely in their loan repayments. The SBA 7(a) loan is a 25-year, fully amortizing loan, meaning that you will not have to refinance. The loan program has a maximum amount of $5 million.
With the SBA 504 loan program, 50% of the loan amount is provided by the bank, 35-40% is provided by the SBA in collaboration with a Certified Development Company (CDC), and the remaining amount is provided by the borrower as equity. Loans under the SBA 504 program can take longer to materialize as they must be approved by at least 3 entities (the bank, the SBA, and the CDC).
It is important to note that, just because a facility does not meet all the requirements listed above does not mean that it shouldn't be considered. Indeed, these deficiencies may represent potential areas of improvement which will allow you to increase the facility's revenue.
There are plenty of things that you can do to add value to an underperforming facility, provided that the reasons for underperformance have more to do with operational inefficiencies rather than broader market conditions. Following are a few examples of steps that you can take to increase the revenue generated by your facility:
Include climate-controlled units in your unit mix. You can do this by converting existing units, or building new ones in parking areas. As many customers may be worried about the adverse effects of temperature and humidity on their precious items, climate-controlled units command a premium over standard units.
Look at occupancy numbers for clues. In the self-storage industry, 100% physical occupancy is not the goal. That might sound counter-intuitive, but high levels of physical occupancy (greater than 90%) usually mean that rents are not as high as they should be. A big gap between economic and physical occupancy may be an indication that you are offering too many promotions, or the level of delinquencies is unacceptably high.
Generate ancillary income. There’s no reason you should be limited to just one revenue stream. You can generate additional income through a variety of sources, such as providing moving supplies, truck rental, and even leasing space to a telecommunications company for a cell tower. One option is emerging as increasingly lucrative: tenant insurance. Tenant insurance provides facility owners with a monthly recurring revenue stream and customers with peace of mind that their belongings are insured.
Expand the leasable area. If you are interested in a facility but it has less than 50,000 leasable square feet, check to see if expansion is possible with the land available. You may also look into the possibility of creating a multi-story storage facility.
This article provided a broad overview of the factors involved in evaluating an investment opportunity in the self-storage sector. To recap, there are a few things aspiring self-storage investors must keep in mind: an analysis of the market in which they plan to locate, an appraisal of the target (or future) facility’s characteristics, and how they plan on financing their investment. The self-storage industry continues to be a lucrative avenue for motivated entrepreneurs to generate income, and we hope this article provided a valuable guide to self-storage investing.