The estimated size of the U.S. self storage market is 25,000 to 30,000 properties, ranging from small facilities with five to six units to large facilities in the institutional-grade class. The top 100 operators control less than 20% of the total number of facilities. The five single-purpose self storage REITs control only 10%, and Public Storage, Inc., the largest REIT, controls about 5%.

Supply and Demand

In the late 1980s, when all property types were in oversupply, developers turned their attention to self storage facilities. The capital flowed freely from lending institutions and institutional investors, and by 1989 self storage markets nationwide were also overbuilt.

However, given the small size of the industry and the lack of additional new construction, it took only four years to absorb the overhang of supply. By fourth quarter 1993 equilibrium had returned, and the market was poised to make another run. Nationwide, physical occupancy was over 90%, as was "economic occupancy." Economic occupancy is derived by dividing actual income collected by the asking rent at 100% occupancy.

During the past two years, the interest in self storage created by publicity from Wall Street has influenced the general public to buy the stock and local bankers to make construction loans. Consequently, development has increased dramatically, and once again the short-term soundness of this market is being threatened.

Value Trends

Self storage continues to be a sellers’ market. Investors tend to buy these properties for a long-term investment because few other investments provide as good a return. Since owners have little incentive to sell, the number of available properties is diminishing. REITs and individuals are the primary contenders for properties that do become available. During 1996 several portfolios of facilities, which had been amassed over the past 15 years, were sold to REITs at record high prices. This is an exit strategy many self storage owners hope to utilize. However, the number of large portfolio acquisitions has decreased from the fast pace of 1995 and 1996 because most first-pick portfolios are gone.

Over the past six years, collections (effective gross income) have trended upward. This is illustrated in Exhibit 1, which is based on an annual sample of several hundred facilities by Self Storage Data Services, Inc. (SSDS), a research firm that tracks the operating performance of more than1,000 facilities annually. The increase in collections is the direct result of improved occupancy due to the lack of new construction between 1990 and 1994. For many operators, this has been a "catch-up" period, since prior to 1991 rental rates had remained nearly flat for several years.

How much longer the upward trend will continue is questionable due to the current amount of new construction. As shown by the line graph in Exhibit 1, collected income has already started increasing at a slower rate.

Economic occupancy peaked at 93% in 1994 (see Exhibit 2). Since 1994 the margin between the asking rent at 100% occupancy and actual collections has widened. Concessions are common in the self storage industry, even in strong markets. However, while some operators ask for higher and higher rents, they must give more in concessions. The decline in economic occupancy has been thought to be the result of too much new construction, but now some owners are beginning to report unexplained drops in occupancies in areas with little or no new construction.

Expenses have been increasing at 3.5% annually for the past five years. Expenses are generally 35.0% to 40.0% of collected income, or $2.00 to slightly over $3.00 per square foot of net rentable area on typical rents of $5.00 to slightly over $8.50 per square foot. Rents and expenses vary with the size and location of a facility.

The rate of future expense increases will depend on the assessment practice of local taxing authorities. Local governments nationwide are looking at self storage assessment practices and are finding ways to increase taxes. For example, in some jurisdictions there is a special tax on outside spaces for recreational vehicles.

As facilities age, a reserve for capital improvements is becoming important. Most operators do not account for or set aside a reserve for replacement. An amount for deferred maintenance is usually negotiated when a property is sold. Typically, roof replacement and repaving asphalt parking lots are the significant maintenance items.

Net operating income (NOI) growth drives the public market, and owners look for ways to increase it. Over the past six years, actual NOI per square foot in the self storage market has increased 8.5% annually. However, given the slowdown in collected income and the increase in expenses, NOI has been rising at a slower rate since 1994 (see Exhibit 3). Nevertheless, it still exceeds 4.0%.

Valuation Methodology

Investors in the self storage market rely on direct capitalization, capitalizing the trailing 12 months NOI, to estimate value. They are concerned about replacement cost only in markets with low barriers to entry, where acquisitions at prices below replacement cost would give them an edge. The prices other investors are paying are significant to them only as they relate to the trailing 12 months cap rate and price per square foot of net rentable area. When capitalizing income, they study a facility’s operating history for trends in income and expenses and look for ways to improve performance. Buyers do not generally use yield capitalization to price an investment, but lenders often require a DCF analysis in appraisals for financing.

Since self storage investors do not rely on DCF analysis, in the past, surveys of yield rates have not been meaningful. However, our experience in appraising and consulting on more than 300 facilities a year indicates that prospective yield rates (IRRs) are in the 13.00% to 14.00% range. Other typical criteria for a DCF analysis are

Our database of 643 sales of self storage facilities over the past 12 years shows that forward-looking capitalization rates (OARs) have ranged between 10.00% and 11.00% for institutional-grade self storage facilities (see Exhibit 4). Excluding the upper and lower 25% of the sample, the median OAR is 10.32%.

In 1995 REITs began to escalate their acquisitions and to compete among themselves for market share. For the first time with any consistency, they bought properties using trailing cap rates well below 10.00%. In forward-looking OARs, they are looking for returns over 10.00%.

In analyzing REIT acquisitions, care must be exercised because REITs commonly do not include off-site management expense, or greatly reduce it when calculating the trailing OAR. REITs are willing to manage third-party facilities, although they would prefer to purchase the properties and collect no management fee.

The cost of funds to REITs remains low, generally between 7.0% and 8.0%, and REITs can purchase properties at lower cap rates than their competitors. Until their cost of funds increases, they will continue to purchase properties at historically low cap rates. Currently, the cost of permanent financing is generally 300 basis points over comparable treasuries, which places the rate at approximately 10.0%. Lenders look for no more than a 75.0% loan-to-value ratio and a 1.3:1 debt service coverage ratio plus 1.0 to 1.5 points. Often an individual cannot compete with the REITs’ lower cost of funds.

We examined sale prices on more than 600 transfers in our database, excluding the upper and lower 25%, to develop trends in prices per square foot and OARs. Exhibit 4 vividly illustrates the declining market conditions of the late 1980s due to overbuilding and the improved market conditions of the early 1990s due to the lack of new construction. Development was again justified by late 1993. Physical and economic occupancies exceeded 90%, rents were climbing, and the median sale price was over $40.00 per square foot.

Development

REITs prefer acquisition to development because of the immediate addition to funds from operations (FFO). The lag time between construction and improved FFO is months. However, with a limited number of facilities available for purchase, development by REITs is increasing. This is being made possible in part by the institutional investors that have come back to the market for the first time since their 1990 pullout. Some are now providing capital for both acquisition and development.

Self storage property is not so closely correlated to overall economic conditions as are other types of real estate. This is one reason for its popularity with investors. Even if the market becomes overbuilt, the length of time to return to balance should be short because demand for space continues to increase. The potential for overbuilding will depend on the size of the wave of capital flowing toward self storage and the ease in accessing it.

Industry Trends

Several changes are occurring in the self storage industry that will impact first-generation facilities. The method of marketing space will change with the use of "phone pools." Some larger operators now employ telemarketers to rent spaces, which has successfully attracted tenants from outside a facility’s primary market. This has boosted occupancy in facilities that historically had low occupancy levels.

Pickup and delivery service could expand demand by offering a choice and attracting users who, for physical reasons, did not previously use self storage. The service is labor intensive and therefore could affect smaller operators without the capital to provide such service.

New high-tech design facilities that resemble big-box retail spaces are starting to compete with first-generation facilities in the inner cities. They have good tenant appeal and offer full security and climate-controlled space.

The long-term future of the self storage industry looks good as it continues to mature and prosper. However, it is not the place for the inexperienced newcomer it was a few short years ago. Competition is keener and management skills have never been more important.

Charles R. Wilson is president of Charles R. Wilson & Associates, Inc. Pasadena, CA.

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