COVER STORY, JANUARY 2012

SELF-STORAGE VITAL SIGNS MOVE UP
Equity REIT returns pack a major punch.
Matt Valley

It was a tale of two different halves for the self-storage industry in 2011. In the first half of the year, occupancy across the Midwest slid to 81.6 percent, well below the historical average, as anemic job growth dragged down occupancy in Indianapolis, Kansas City and Chicago, according to Marcus & Millichap Real Estate Investment Services.

During the third quarter of 2011, however, occupancy rates bounced back as minimal new construction, a weak single-family housing market and job growth led to heightened demand for self-storage space.

“Occupancy levels in Indianapolis, Kansas City and Detroit returned to their historical norms, and most metros showed improvement in the third quarter,” says John Chang, vice president of research services for Encino, California-based Marcus & Millichap.

Average occupancy at self-storage facilities in the Midwest spiked 170 basis points in the third quarter to 83.3 percent and was projected to finish 2011 at 84 percent.

Meanwhile, average asking rents rose 2.6 percent in the third quarter to 78 cents per square foot, and were expected to reach 80 cents per square foot by the end of 2011.

Big changes in people’s lives fuel the self-storage industry — a death in the family, disaster or divorce. “We call it the three D’s that drive the demand in our facilities,” says Clemente Teng, senior vice president of investor services for Public Storage (NYSE: PSA). The giant publicly traded real estate investment trust (REIT) based in Glendale, California, owns more than 2,000 self-storage facilities in 38 states, including nearly 330 properties in 10 Midwest states.

Most Americans will likely need to use a self-storage facility at some point in their lives, says Teng. “If you buy a new place and sell the old one before you can move into the new place, what do you do with your stuff? You have got to put it in storage temporarily. Or if you are doing a remodeling job and you’ve got to move items out of your kitchen, where are you going to put it all?”

REITs Serve As Bellwether

Total returns for the self-storage equity REIT sector were up 28 percent year-to-date through Dec. 15, 2011, according to the National Association of Real Estate Investment Trusts (NAREIT). Improving real estate fundamentals are a big reason.

The same-store occupancy rate in Public Storage’s portfolio averaged 91.7 percent in the third quarter of 2011, up 1.3 percent from the third quarter of 2010. (Same-store occupancy is a metric used to track performance at facilities open for at least a few years).

All of the top 20 markets in which Public Storage operates posted revenue growth in the third quarter. The Minneapolis and Dallas markets led the way with revenue growth of 8.5 percent compared with the same period a year ago.

Among the four equity REITs in the self-storage arena, same-store net operating income (NOI) rose 7.93 percent in the third quarter on a year-over-year basis, according to Jason Lail, real estate research manager for Charlottesville, Virginia-based SNL Financial. By comparison, same-store NOI at non-self storage REITs climbed 2.2 percent during the same period.

Self-storage REITs use debt conservatively. The ratio of total debt to total capitalization for self-storage REITs is 30 percent compared to 43 percent for non-self-storage REITs, says Lail. “They have been good shepherds on the balance sheet, and have really been diligent in reducing leverage and taking advantage of that recapitalization period.”

The other good news for self-storage owners is that the development pipeline has slowed to a trickle in recent years. Fewer than 250 new self-
storage facilities came on line nationally in 2010, according to the Self
Storage Association. That pales in comparison to the nearly 8,700 facilities built over a 2-year period beginning in 2004. Many communities frown on self-storage because they don’t think the facilities do much to assist their tax base, says Teng of Public Storage.

Several cities have a moratorium on building permits for self-storage. “Most self-storage facilities do not provide a great employment base.  [Cities] have been moving toward retail or multifamily,” says Teng.

Because of the dearth of new product, small increases in demand for space will have a strong impact on occupancy and could lead to higher rents in the coming year, says Lail.

Under the hood

Several underperforming Class B and C self-storage properties that sold in the Midwest during the second half of 2010 and first half of 2011 pushed down the median price nearly 20 percent to $26 per square foot, according to Marcus & Millichap. That drop followed a 22 percent decline in the median price the previous year.

“The median price declined each year due to an uptick in REOs, short sales and distressed sales,” says Chang of Marcus & Millichap. “From mid-year 2008 to mid-year 2009, only a few REO sales took place. The following 12 months, troubled, older properties with deferred maintenance dominated sales activity, driving the median price down more than 20 percent.”

Private buyers will pay cash for highly vacant Class B and C facilities in Michigan, for example, to capture the potential upside, says Chang. Troubled assets will trade below replacement cost and can generate returns in the “low-10 percent range.”

Several transactions that recently closed in the Midwest were triggered by some sort of distress such as high vacancies or a lack of available financing with acceptable terms, says Jim Pitoukkas, an advisor with Sperry Van Ness/Sycamore Commercial in Carmel, Ind.

“These smaller, private buyers need to pay cash, or purchase at a very low loan-to-value, in order to take advantage of these opportunities,” explains Pitoukkas. While that’s occurring, the larger operators are aggressively pursuing prmary markets.

Capitalization rates for stabilized, quality assets in the major MSAs are hovering around 7.5 percent, says Pitoukkas. In secondary and tertiary markets, cap rates typically range from 8 percent to 10 percent, depending on the location and age of the property and the surrounding demographics.

The word is getting out that investment returns in the self-storage sector have proven to be more dependable than many other commercial real estate asset classes.

“These new institutional buyers, along with the REITS  and private buyers, have kept the market competitive for good product to acquire,” emphasizes Pitoukkas. Cap rates climbed in the wake of the Great Recession, but investor demand never faded away.

“The biggest difference I’ve noticed in terms of valuation is that buyers are now very rarely willing to pay for future performance,” says Pitoukkas.

While REITs and institutional investors are leading the acquisitions pack, a number of other high-net-worth individuals also are looking for properties, says Pitoukkas.

“We are getting calls from a variety of prospective buyers that represent every sector.  As more debt options become available, I believe more private individuals will come off the sidelines.”

Public Storage’s strategy is to own and operate self-storage facilities in submarkets with a high density of population. Cap rates are not the determining factor, says Teng.

“It’s a 3- to 5-mile radius business. As long as you have people, density, you have a good chance that the local facility is going to do very well.”

Although the Midwest accounts for a relatively small piece of Public
Storage’s overall portfolio, the company has a strong presence in the Windy City. Public Storage owns and operates approximately 125 facilities in metro Chicago, primarily in suburban areas such as Skokie, Elk Grove Village, Schaumburg, Mount Prospect and Arlington Heights.

“We are in the burbs a lot where there is a high density of home ownership, or apartments where there is a density of people,” says Teng.

Future consolidation

There are approximately 46,500 self-storage facilities nationally, reports the Self Storage Association. The four equity REITs — Public Storage, Extra Space Storage, Sovran Self Storage and CubeSmart — own less than 10 percent of the facilities, estimates Teng. “It’s still a very fragmented industry of mom and pops and individual entrepreneurs operating these facilities.”

The top 20 operators in the U.S. control less than 20 percent of the total self-storage market, says Pitoukkas. Meanwhile, the REITs have a tremendous amount of capital available and are looking for available properties.

“Moving forward, more consolidation is anticipated in the industry, which ultimately will lead to a growing competitive advantage for larger operators,” says Pitoukkas. “Independent operators with strong locations should be able to remain competitive.”

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