Self-Storage & Wall Street

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

Cash Is Flowing!

The self-storage industry presented two faces throughout 2017. On one side, there were widespread reports during the first half of the year of decelerating rental growth, revenue, and occupancy, and hints of discounting. In the second half of the year, the storage real estate investment trusts (REITs) reported robust occupancies and improved revenues.

Early in the year, REIT acquisitions were down substantially, but it’s believed the public companies spent freely on portfolios in the fourth quarter.

Self-storage operators, consultants, and lenders were nervous about the number of new developments sprouting around the country, but they still pointed to pockets within oversupplied markets where new facilities could thrive.

Wall Street lenders and analysts have become more sophisticated in their knowledge of the industry, so this news comes as no surprise to them. Nevertheless, Wall Street still looks favorably on self-storage fundamentals and tends to buy into the market.

“Returns year over year have been greater than other real estate sectors and now, even at a slow-down pace, it’s still at a level equal to or better than other property sectors,” says Neal Gussis, principal at CCM Commercial Mortgage in Skokie, Ill. “Now that we’re getting closer to the end of the cycle, institutions are looking at self-storage and saying it’s just as good as other sectors, if not better.”

Some observers believe Wall Street is “cautiously optimistic” about the state of self-storage. In fact, with the possible exception of development projects in certain areas, the capital markets are flooding self-storage with investment funds for acquisitions, refinancing, and expansion.

“For self-storage Wall Street lenders, the spigots are on high; they haven’t slowed down whatsoever,” says Gussis.

Adds Steve Libert, a CCM principal, “If you put your mouth over the faucet of Wall Street debt money coming into the business, you’d drown.”

This may not be an exaggeration as many investors are eager to enter the storage sector. Some of this money is contributing to the glut of new development, while other funds are driving the prices of some portfolios out of the reach of the REITs.

A Drop In Acquisitions

Following several years of rising property values and a feeding frenzy at the acquisition trough, 2017 turned out to be a year of reckoning for many self-storage owners. Capital has been readily available, and many potential buyers kicked the tires on facilities that were on the market, yet there was a significant drop-off in acquisitions.

“We have ongoing discussions with owners, and they feel like it’s a good time to be a seller, but are they ready to act? For them it’s a big life decision to sell,” says Zach Dickens, senior vice president of real estate for Extra Space Storage, a Utah-based REIT. “Some larger operators still like the fundamentals of storage, so it’s always a question about what is a good time to sell or should we keep building our platform? It’s still very enticing with pricing today for owners to at least think about selling, but I don’t get a sense that we are going to see a tremendous amount of volume.”

Through the first nine months of 2017, REIT acquisitions dropped between 63 percent and 70 percent from the previous year, according to real estate brokers who study the REIT sector. While there are indications Extra Space and other REITs opened up their wallets during the fourth quarter, it still appears last year’s results were going to seriously trail previous years’ acquisition activity.

Were REITs more selective in their purchases, or were sellers dug in on their sales prices?

“REITs do a dance where they’re interested, but they can’t overpay and destroy value for their shareholders,” Dickens says. “In the first half, sellers put out feelers, and they weren’t getting the numbers they wanted, so their inclination was to pull back. There is a point where the seller has to reset their expectations based on market conditions.”

The lower acquisition activity was not limited to REITs. Wayne Johnson, CIO of SmartStop Asset Management, reports the company’s acquisitions fell to approximately $150 million in 2017.

“We looked at quite a few opportunities and bid on plenty, but we were not going to get pulled up in price, so we watched many deals go to somebody else who was willing to pay more,” Johnson says.

SmartStop is the sponsor of Strategic Storage Trust and other public non-traded REITs based in Ladera Ranch, Calif.

Among the reasons for the dearth of acquisitions Libert cites are a lack of supply and private equity coming into the market and inflating prices. “Also, the bid/ask widened because sellers continued to think that cap rates are going to go down, and they leveled out at a low cap rate,” Libert says.

It appears the substantial stock price hits the REITs suffered in 2016 may have caused public companies to become more cautious about spending freely for acquisitions following several active years. “Portfolios were taken out by the REITs in ‘14, ’15, and ’16, prior to the stock price hits on storage REITs, and so they backed off and institutional investors stepped in,” Gussis says.

Following a -8.14 percent decline in stock prices in 2016, self-storage REITs recovered to a modest 3.74 percent gain last year, according to NAREIT, an advocate for the REIT industry.

Dickens believes Wall Street had a “prove it” mentality toward the REITs at the beginning of the year, as there was a concern about slowing rate growth. “We were coming off double-digit revenue growth years, and there was clearly a slowing that was happening in rental rates,” Dickens says. “When it became more evident through the first three quarters, people saw it wasn’t as bad as it was reported to be.”

Private Equity’s Impact

Private equity funds have had a profound effect on the face of self-storage in recent years as millions of dollars of investment money came into the industry from new sources.

“Institutional private money discovered self-storage over the last five years and have been very aggressive over last two or three years,” Libert says. “Institutional quality and competition was up from private equity in a huge way, which raised sellers’ expectations way up.”

While the REITs may have shied away from mega deals, there was still plenty of money available for storage acquisitions. For example, Sitar Realty Co. announced in November the $124.4 million acquisition of 6,272 storage units across a dozen Northeast cities by Saratoga Springs-based Prime Group Acquisitions.

Prime Group, a real estate company that owns self-storage and other real estate interests, acquired a storage facility from Madison Development in the Brooklyn, N.Y., area for $53 million.

While storage REITs CubeSmart and Life Storage had no acquisitions in the third quarter, Tampa, Fla.-based SkyView Advisors reports that National Storage Affiliates REIT spent $123 million on property buys during the quarter.

Late last year, Strategic Storage Trust II completed the purchase of 11 facilities in Asheville, N.C., for more than $92 million. The acquisition was the final phase of a 27-property portfolio initiated in March 2016. The entire portfolio represents a combined investment of $371 million.

REIT volume appeared to pick up in the fourth quarter. “Our fourth quarter was very active,” says Extra Space’s Dickens. “We closed more in the second half of the year than in the first half.”

The fourth quarter activity may be a springboard to a better transactions year. “The brokers believe that 2018 is going to be better than 2017 when it comes to deals coming to market,” Dickens says. “The question is whether the REITs will be willing to come out in earnest and buy it up. Last year it was private equity filling the void if the REITs didn’t want to get as aggressive.”

Strategic Storage’s Asheville acquisition could serve as a harbinger of more headline-grabbing news from SmartStop. “We have quite a bit in the pipeline,” Johnson says. “From our side of the table, it should be a better year if sellers are willing to recognize interest rates are rising.”

SkyView reports that smart investors are taking advantage of the current marketplace conditions to monetize their assets before this expansion cycle comes to a close. Also, sellers may soon modify their asking prices.

“We are going to see many more reasonably priced assets coming to market as less prepared owners try to get out late in the game,” SkyView says.

Construction Financing May Wither

Construction financing has been readily available over the past couple of years, according to the 2018 Self-Storage Almanac. But the storage industry’s current development cycle is producing a level of new supply that has not been seen in over a decade. This will surely impact rental rates and occupancies in saturated markets. Lenders know this and have scaled back loan-to-cost funding for new construction.

“Construction money will be more difficult going into 2018 and beyond, because lenders have seen this before and start to pull back,” Libert says. “Lenders that were in the construction business in 2015 to ‘16 are more measured in 2017 and will continue to be more selective in 2018.”

Dickens notes that more lenders today are placing self-storage development in the high-volatility commercial real estate (HVCRE) category. HVCRE properties are considered more speculative, since they typically don’t have tenants at the beginning of construction.

The HVCRE rule, which went into effect in 2015, increased the risk weighting of a loan held on a bank’s balance sheet by 50 percent. The rule dictates that loans are required to stay designated as HVCRE until the credit facility is converted to permanent financing, sold, or paid in full, according to the American Bankers Association.

“What that means for developers typically is they aren’t able to borrow as much on a loan-to-value basis,” Dickens says. “That entails limits on making loans to HVCRE properties. That’s going to put downward pressure on the amount of loans being generated.”

Banks, as well as other lending sources, are going to tap the brakes on new self-storage development this year, although new stores will certainly begin construction in areas where owners deem a need exists.

“It’s going to separate out lucrative new development deals from marginal development deals,” Libert says. “Borrowing costs on new construction is going up, but also we’re in a boom cycle now, so the cost of materials is going up, so margins on development deals are getting compressed. Developers are getting more selective on the deals they’ll do, and lenders are more cautious, so it eliminates marginal development deals and less experienced developers. Only the best deals with the most experienced developers will get more attention from lenders.”

Capital Sources Flowing

Self-storage has attracted interest from new investors since the Great Recession, when the sector fared better during the economic downturn than other real estate categories. Sources of capital for storage is expanding and available for financing.

Commercial mortgage-backed securities (CMBS) have been readily available for self-storage over the years, although this source has had its ups and downs.

The Almanac reports total U.S. CMBS issuance reached $101 billion in 2015, marking the largest annual volume since the recession hit in 2007. With the implementation of the risk retention rule, several CMBS lenders left the market. In 2016, CMBS issuance was down nearly 25 percent, but CMBS rebounded to over $86 billion in 2017, according to Trepp, a New York provider of data, analytics, and technology solutions.

“The CMBS market is as aggressive as ever in the self-storage arena,” Gussis says. “They are offering interest-only periods up to 10-year terms. That increases monthly cash flow when you don’t have principal pay down for 10 years, so it’s maximizing cash flow for a 10-year period.”

Gussis says it’s still possible to get CMBS rates in the low four percent range.

CMBS loans are non-recourse debt products that typically feature five-, seven-, or 10-year fixed-rate terms. Borrowers can achieve leverage up to 75 percent or higher. Some CMBS lenders also compete for loans as low as $1 million in secondary or even tertiary markets. This is especially important for self-storage owners with transactions in the sub-$5 million range.

Life insurance companies have been rising in importance in self-storage lending. “Life insurance companies have gotten very aggressive over the last year or two,” Libert says. “We’re closing loans with life companies in 3.7 to 3.8 percent for 10 to 15 and sometimes 20-year fixed.”

The typical insurance lender prefers high-quality, stabilized assets in core markets. Life companies have historically targeted loans over $5 million, but the current competitive landscape has encouraged some to stretch for smaller deals, according to the Almanac.

To remain competitive and win deals, banks are increasingly offering seven- and 10-year fixed-rate term loans at attractive interest rates, with leverage available up to 75 percent LTV.

Credit unions have become an increasingly relevant financing source for storage. While most banks prefer to lend in a designated footprint that largely follows the institution’s presence based on relationships with their existing clients, credit unions will lend nationally and often to a borrower with no preexisting relationship.

For construction loans, a local or regional bank is the most likely capital source for a developer with a viable project. Lenders prefer guarantors with strong balance sheets and significant development experience. Accordingly, banks are still offering construction loans across the country, but are proceeding with caution.

Small Business Administration (SBA) loans are made to small business owners by a bank and are partially guaranteed by the government. SBA financing has proven beneficial to self-storage owners in non-primary markets, where traditional financing may be more difficult to obtain, as well as those looking to surpass the typical 75 percent LTV threshold.

SBA loans tend to be document-intensive, and the closing process can be lengthy. When applying for SBA financing, seek out a Preferred Lender Program (PLP) certified lender. PLP lenders can approve loans on behalf of the association, which can speed up the process.

The Fed Damper

With banks tightening regulations and other lenders wary of self-storage’s development growth, the Federal Reserve’s expected rate hikes this year could put a further damper on capital for some operators.

“Fed rates affect short-term rates much greater than long-term rates, so that would affect construction and bridge financing, because those are adjustable loans that are pegged to shorter term rates,” Libert says. “The jury is still out on how much that will affect the seven-year loan, 10-year loan, or 15-year loan.”

The Fed rate hikes will affect the cost of capital for the REITs as well as smaller operators. “You’re going to see a little increase in cap rates, because people’s cost of funds is going up as a result of these hikes,” Dickens says.“The question is, do cap rates today reflect those increases already? The expectation of it going up is often baked into deals today.”

Wall Street lenders will weigh several factors this year as they consider further investments in storage.

“Wall Street today is looking at the major REITs and watching our performance very closely to get clues about our ability to push rents,” Dickens says. “We’re experiencing all-time-high occupancies among REITs, we’ve had outsized growth for the last few years, but the question is, will that continue for the foreseeable future? That’s where they’re trying to see if we’re able to keep up the momentum we’ve been able to generate over the last few years, particularly in light of new construction starts and those that are being delivered this year.”

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