Pawns Of Price

Posted by Poppy Behrens on Sep 1, 2018 12:00:00 AM

Stalemates In The Sales Process

According to one source, there may be $400 million in self-storage properties that have sat on the sales market for more than two years. By all accounts, storage facilities have never been worth more and experts generally believe self-storage fundamentals remain strong, yet these properties are seemingly growing cobwebs on their “For Sale” signs.

So, what gives?

Many real estate professionals are noticing a growing disconnect between prospective sellers and buyers. They contend that these sellers believe their properties are worth more than buyers are willing to pay, or owners are finding other alternatives to selling at this time.

While self-storage has ridden a recent wave of profitability along with rising rental rates, occupancies, and valuations, many buyers can recite a laundry list of reasons for concern: interest rates are on the rise while a virtual building boom in many markets is creating a competitive environment leading to declining rental rates and occupancies.

“The disintermediation between buyers and sellers is driven by buyers having to adjust their expectations around the increasing cost of capital and real time factors, whereas sellers tend to look in the rearview mirror and feel like they should get the price they’ve been reading about over the last three years,” says Shawn Hill, a principal of The BSC Group in Chicago.

The prospect of selling an asset that has produced reliable cash flow and grown in value over recent years is a life-changing decision for some owners. Is it the right time to sell? Where will I invest the proceeds of the sale that will provide similar returns to self-storage? Is refinancing a better alternative?

Meanwhile, real estate investment trusts (REITs), private equity (PE) firms, and other investors have ready cash to either expand their storage holdings or enter the industry for the first time.

Buyers and sellers have their own opinions of what a property is worth, and this is creating a stalemate in the sales process.

“We’ve seen listed deals, as well as off-market deals, not transact due to gaps in valuation expectations between sellers and buyers,” notes Michael Rogers, vice president of real estate for Life Storage, a Buffalo, N.Y.-based REIT. “Cap ex requirements, property tax impact, and closing costs all eat into a buyer’s going-forward yield. A good broker will manage that process for an owner and lay out realistic expectations.”

The Role Of C/O Properties

Not everyone is necessarily buying into the notion that this disconnect is widespread in the market. “It’s tough for me to believe the buyer/seller disconnect is playing as much of a role as some are suggesting, because you have a significant pool of buyers telling you what something is worth,” says Aaron Swerdlin, vice chairman of NKF Capital Markets in Houston. “A lot of the seller/buyer disconnect is on the same pool of properties.”

He’s referring to NKF’s data indicating a significant number of storage facilities have yet to change hands after two years. “That tells me there’s $400 million worth of owners who, if they can get their number, are going to sell,” Swerdlin says. “The C/O [certificate of occupancy] market has rapidly become a big part of the transaction market. If there is a macro disconnect between buyer and seller, it’s within the C/O market.”

C/O properties generally are new construction sites that are developed in hopes of having a ready buyer—such as a REIT or other large operator—once the doors open for business. Unlike traditional acquisition properties that may be stabilized with high occupancies, C/O facilities start with virtually no tenants and take two to three years to lease up. And that’s the rub for buyers who fear changing market fundamentals.

Bill Alter, managing director of Rein & Grossoehme’s Self Storage Group in Scottsdale, Ariz., has noticed several C/O offerings that lack any takers. “I see properties for sale, particularly those offered as C/O opportunities, and brokers are marketing call for offers dates, that date comes and goes and then they’re marketing another call for offers date,” Alter says. “It’s clear evidence they haven’t gotten the numbers they were hoping for.”

Marcus & Millichap is expecting 48 million square feet in new C/O completions this year. With so much new development expected to come on line, many prospective buyers will likely balk at paying top dollar for C/O properties that could take years to stabilize in competitive markets.

“The problem is you’re probably two years on average from the day you say you’re going to build a self-storage facility to the day you’re renting your first unit,” Swerdlin says. “Two years ago, the market was a lot more bullish on how they thought about rental rates going forward. We were seeing REIT reports on same store revenues in the high single digits every quarter, so they trended their rents. If it was a $12 market back then, maybe they trended a $14 market by the time they start renting units, but they’re finding it’s a $10.50 market.”

Swerdlin says owners still have confidence that they can fill up their new facilities by creating demand by adjusting pricing and sweeping in new tenants through the internet, call centers, and other marketing programs.

“Most of them are leasing it up fast enough, but they’re not hitting their revenue proformas,” Swerdlin says. “A lot of them will get to 90 percent occupancy, but I’m going to be 15 percent short on revenue because rental rates are so much lower, and I think that’s where the disconnect is coming from. They’re trying to sell a property with a proforma two years ago and buyers today are too smart to take a risk on rental rates or believe rental rates will be significantly higher two years from now.”

The industry has experienced a recent protracted period where investors could always count on increasing rents and healthy occupancy going forward. But with so much new supply coming into certain markets, storage may be in a situation where owners can’t count on that type of growth over the next two or three years.

“If you combine the increasing cost of capital with challenged fundamentals going forward, one could make a case that values two years from now are not increasing; more likely they will be flat, and they may even be lower,” Hill says.

2017 Volume Declines

The buyer/seller disconnect may have contributed to the lower self-storage sales volume seen last year. Industry experts acknowledge the transaction volume was down in 2017 compared to the previous year.

“No doubt that 2017 was down,” Rogers says. “I think there was deal flow coming to market in 2017, but just not a lot of really big deals. In some cases, owners were waiting on the sidelines to see how tax reform would impact their status. 2016 saw some really big deals, and 2018 is definitely ahead of ’17 with respect to overall deal flow coming to market.”

The REITs contribute to a significant portion of annual acquisitions, and their reluctance to go all in last year had a dramatic effect on the market. In its fourth quarter “2017 Self Storage Industry Report,” SkyView Advisors says, “Acquisition volumes are down across the board for all of the REITs. Total transaction volume is down 78.5 percent year over year.”

When the REITs decide some acquisitions are too rich for their blood, other operators and private equity companies step up to the transaction table. Their activity helped to buoy the market somewhat.

“I wouldn’t say ’17 was dramatically lower, but ’18 is probably not as active as ’17, and ’17 was less active than ’16,” says Wayne Johnson, CIO of SmartStop Asset Management in Ladera Ranch, Calif. “I think ’15 and ’16 might have been headed toward a peak as far as activity.”

SmartStop reported just under $150 million largely in stabilized and C/O acquisitions in 2017, and Johnson expects the company’s acquisition activity will be comparable in 2018.

Real estate brokers remain optimistic about future sales in this current sales cycle.

“We are peaking,” says Alter. “I don’t think we’ve begun a decline yet. This has been a long lasting good time, but it’s not going to last forever. There is too much being built in too many markets, and I’m afraid not only will those overbuilt markets suffer the consequences, but they’ll drag down some markets where there may not be as much overbuilding.”

Other brokers acknowledge that the duration of the current sales cycle may be approaching an end. “From my perspective, we’re in the later innings of the ballgame, but it doesn’t feel like we’re in the ninth inning, or maybe this cycle is going into extra innings,” says Hill. “Historically speaking, cycles tend to run about 10 years, so history is starting to work against us. But we’re still seeing a robust level of activity.”

A Good Time To Sell?

While a number of owners are still contemplating the decision whether to sell or hang onto their properties, the window may be closing on the best opportunities to attract the highest offers.

PE companies and other investors are still seeking to get into the storage business, but that interest may become muted down the road.

“I think it is a great time to sell or refinance today because, despite the fact that there may be some things that are changing in the market, cap rates are still very low, debt is historically cheap, and self-storage fundamentals are very good,” Hill says.

“If it’s a property that’s not inundated with new competition, if it’s stable, I can’t imagine there’s been a better time to sell,” Swerdlin says. “There’s more capital looking to invest into self-storage today than there has ever been before. The momentum of the market is absolutely in the seller’s favor.”

Plus, there appears to be no shortage of buyers ready, willing, and able to purchase at the right price.

“There’s a steady stream of buyers out there,” says SmartStop’s Johnson. “There’s always a supply of something available to buy. It’s a matter of does it make economic sense for someone like us to buy it? In some cases, facilities lease up and they’re doing great and income is solid. In other cases, physical occupancy comes in strong but economic occupancy lags from their original proformas. We’re in an optimistic but cautious mode, because how do you project where something is going to land in two or three years?”

Owners who are seriously considering selling their properties but are slow on the draw could be in danger of missing the mark. If their stores are priced unrealistically high for the market, buyers may pass them by.

“There is a real risk that they could miss the market by overpricing their property, and when they figure that out, it’s costing them a lot of money because it’s further down that downward path,” Alter says.

Selling a property is like aiming at a moving target. “When you come to sell a property, you have to aim at pricing so that it intersects with the trend line of the market,” Alter says. “If that’s a downward curve, the comps will mislead you into thinking your property is worth more than it is. If your market is moving upward, you can price higher than the comps. If your market is moving downward, you’re going to have to be lower than the comps.”

Looking at sales comps over the last 12 months can paint one picture, but if the market is peaking or beginning to decline, purchase offers may be on the low side. Alter advises owners to find out what buyers are telling brokers or other sellers about what it will take to buy that property.

“What has affected value is rents are being underwritten at a lower number, occupancy is being underwritten at a lower number, and the cap rate is going to stay the same,” Alter says.

The Refinance Option

In the recent past, The BSC Group transacted much more acquisition-related financing than the firm does today, as clients focus more on refinancing.

“We do a lot of work for mid-market and smaller operators, and those buyers are having a hard time competing to win deals from the more institutional buyers,” Hill says.

BSC was involved in one recent deal where the client planned to sell several properties to a buyer who later wanted to renegotiate the terms and purchase price. “The seller was not amenable to that change in deal terms and elected to refinance instead of selling the properties,” Hill says. “They chose refinancing rather than selling, since they weren’t going to get the price they were looking for.”

That refinancing alternative is playing out more often this year because some owners are finding they can extract higher value for their properties than with a sale. Hill explains it has to do with how different parties evaluate the same property.

“In a sale, you’re working with a buyer, which is likely backed by institutional capital or potentially even a REIT, who is working off real-time information,” Hill says. “If they think rates will be flat or trending downward because of new supply coming in, or that occupancy may be challenged, they’re factoring that into their buying decisions. Whereas in a refinance scenario, the appraiser is looking at comps and basing cap rates and values around historical data.”

An appraiser may give a property a higher valuation than what a seller would receive through a purchase because the appraisal is primarily grounded in historical data, whereas a buyer’s information is based in real time and forward projections.

A New Breed Of Buyer

Competition remains fierce among buyers searching for good properties. “If you put a property on the market, it’s going to get a lot of attention,” Alter says. “It’s going to collect a lot of offers, but they’re going to be lower than you thought it was going to be. There is still a strong buyer demand at realistic underwriting.”

As self-storage has gained investor attention in the past several years, a new breed of buyer has emerged. Buyers today are more educated about storage.

“I’ve never seen the buying community be as smart as we have now,” Swerdlin observes. “They understand the product type, they understand underwriting, and they understand the rental rate market. This is the smartest pool of buyers I’ve ever seen.”

Buyers and sellers still need to get together if both parties are serious about completing a transaction. There must be a number somewhere in the middle that puts the gears in motion.

“I’ve always seen a gap between seller expectation and buyer reality,” Johnson says. “It’s probably more so now than in the distant past, because as markets change, as interest rates rise, or as cost changes in the operation, it is tougher to come up to the number sellers want.”

David Lucas is a freelance writer based in Phoenix, Arizona. He is a regular contributor to all of MiniCo’s publications.