It's a Smart Time to Sell! Why Your Property May Be at Peak Value

March, 2012

Reflecting on the past several years of tremendous upheaval in the financial markets, I find myself going back to a prevailing thought... now is a great time to sell. Not for everyone, but definitely for some. By nature I am not a contrarian, and as a mortgage broker that makes a living earning fees by financing assets - not selling them - this position is certainly not self-serving. Nonetheless, the bottom line is that for some investors the stars are aligned and right now would be a smart time to sell.

The age old concept of "buy low sell high" holds true during any economy-boom or bust. Without question the most difficult part of executing on that philosophy is having a clear understanding of what is "low" and what is "high". Popular opinion today would certainly lead you to believe that we are on the "low" side of the cycle, but as another age old adage goes, "don't believe everything you hear," because for some today may in fact represent a peak value.

Macro Conditions

On the surface, there are many reasons why people would initially think now remains among the worst times to sell. For starters, almost everything you read in the media is negative. In terms of housing data, new home sales and pricing are far below historical levels, and while improving, 2011 was certainly not a banner year.

The labor market isn't exactly a reason for optimism either. The official unemployment rate persists around 9 percent, while the U6 number (what some call the "real" unemployment rate) is still hovering above a dismal 15%.

CRE Prices Still Unstable

In general, commercial Real Estate (CRE) values are down more than 30% across the board from the highs just a few short years ago. Although they are not self-storage property specific, the graphs below illustrate the magnitude of change present for the four major asset classes over the past decade or so with respect to two major indicators - vacancy, and price.

Lack of Liquidity in the Market

Although improving, debt is not as readily accessible as it was just a few years ago for many potential buyers. Lenders currently require higher levels of equity and have very stringent underwriting guidelines with little flexibility. In today's market, advance levels are generally capped at 75% of value, with many deals limited to 70% or less. In addition there are many non-cash reserves built into the underwriting, including management fees (whether they truly exist or not) and capital expenditure reserves. These factors limit the amount of debt available to buyers, requiring additional equity to transact effectively; this in turn constrains the number of qualified potential buyers.

In consideration of all of these factors, conventional wisdom would lead most people to the conclusion that now may be among the worst times to sell. A more careful consideration of the facts, however, may lead to a different conclusion altogether.

Deal with Facts: Avoid Jumping to Conclusions

Despite all the rhetoric, a quick review of the actual facts and data available may actually tell quite a different story.

Economic Improvements

While the economy is still struggling, on a technical basis it is finally improving. With GDP growing at an annual rate of 1.8% in 3Q 2011, we are no longer technically in a recession, and there is a growing general consensus that "back-to-reality" pricing for residential real estate, after the overinflated period prior to 2008, will ultimately be a "good thing" for the US economy as a whole. The latest jobs report was also very positive as the economy added 200,000 jobs in December 2011, bringing the unemployment rate down to 8.5%, its lowest level since February 2009.

Access to Affordable Capital

Debt is a critical component of the capital stack, and as such it is very important that buyers have access to sensible debt in order to transact. Thankfully, lenders began to open their coffers in 2011. Psychologically, lenders are feeling that the worst has passed; anecdotally they were much more active in 2011, a trend that should continue in to 2012.

Notably, the CMBS market witnessed a dramatic increase in originations in 2011. According to Fitch Rating, there was $43 billion of CMBS bonds issued in 2011, a 150% increase over the $17 billion issued in 2010. Other capital sources also increased origination; life companies, for example, which originated a mere $20 billion in 2010, originated in excess of $35 billion through 3Q 2011. All signs indicate an equally productive 2012, with CMBS originations expected to match those achieved in 2011.

Simple supply and demand economics would suggest that an increase in (access to) capital will effectively increase the number of qualified potential buyers with access to capital. Additionally, over the past 12 months, benchmark indices have reached historically low levels, with fixed rate permanent debt in the 5% range a reality for many investments today.

For those old enough to remember the era of inflation in the late 1970s and early 1980s, commercial mortgage rates of 18-20% were the norm. During the savings and loan crisis of the early 1990s, similar rates prevailed. For those with a shorter term memory, from 2008-2010, the very limited debt that was available was relatively expensive and very difficult to access.

Access to affordable debt is good for sellers because it allows buyers of property to pay more and still meet their equity return hurdles. Luckily for sellers, debt is currently cheap, from both a long term and short term perspective.

Cap Rates and Market Comps

Although Commercial Real Estate (CRE) values are still down across the board from the highs just a few short years ago, significant progress has been made over the past 12 months, and there are visible signs of stabilization in the commercial markets. Stabilized vacancy rates have led to increased revenue, cap rate compression, and in turn, an increase in market values; there is optimism that these trends should continue in 2012.

One of the most basic methods of calculating value is to divide the net operating income (NOI) by the property-specific capitalization rate ("cap rate"). Generally speaking, cap rates are an indicator of perceived risk; as perceived risk decreases, value increases; by corollary, as cap rates decrease, real estate value increases.

A review of some of the actual self-storage transactions that have recently occurred in the market indicates that there may be lower cap rates and higher values than might be expected. In fact, the self-storage market is witnessing a recent decrease in cap rates to levels approximating those experienced before the recession.

One of the largest self-storage transactions in 2011 was CubeSmart's acquisition of the Storage Deluxe portfolio in the New York City metro area on 22 properties totaling 1.6 million square feet for a purchase price of $560 million, with an estimated cap rate of 5.8%. Although this transaction may represent the apex in terms of quality, location, and demographics, other premium transactions also traded below 7.0%. Notably, Sovran Self Storage purchased a portfolio of stabilized properties in New Jersey and Eastern Pennsylvania with a cap rate of approximately 6.8%. Clearly the REITs see value in the market and are willing to aggressively pursue high quality storage properties nationwide, which are viewed as accretive to their portfolios.

With respect to cap rates for the self-storage industry as a whole, R. Christian Sonne, Senior Managing Director at the Self-Storage Group of Cushman & Wakefield, explains that "overall capitalization (cap) rates and yield rates continue to decline in the domestic self-storage market, albeit at a slower place." (1) According to his report published in early 2011, residual cap rates decreased from an average of 8.75% in the second half of 2009 to 7.75% in the second half of 2010. The trend line is clearly downward sloping, signaling an increase in values and for those savvy investors with limited remaining upside, potentially a prime time to sell.

Opportunity May be Knocking: Understanding the REIT Mentality

In simplified terms, a real estate investment trust, or REIT, is a company that owns and/or operates income-producing real estate. As a rule, a (REIT) must distribute at least 90 percent of their taxable income to shareholders annually in the form of dividends. To accomplish this and meet their investors return expectations, REITs require income producing properties in their portfolios. Therefore, REITs are inherently attracted to performing assets because of the consistent cash flow they provide to investors; as such stabilized and well-located self-storage facilities are very appealing to the REITs.

According to the December 2011 Media Update released by the National Association of Real Estate Investment Trusts (NAREIT), self-storage was the top-performing asset class on a trailing 12 month basis through November. Self-Storage REITs generated returns of 40.0% over that period, compared to 13.5% for apartments, 11.5% for office, 0.1% for retail, and -0.2% for industrial. (2)

There are four large publically traded REITs that currently focus almost exclusively on self-storage, namely:

  • Public Storage - the world's largest owner and operator of self-storage facilities, with more than 2,000 self-storage facilities located in 38 states.
  • Extra Space Storage - an owner/operator of more than 800 self-storage facilities in 34 states. In 2011, ExtraSpace purchased 55 properties for a total purchase price of $289 million.
  • CubeSmart - owns or manages more than 450 facilities across the United States. CubeSmart was involved in 2011's most notable acquisition, the aforementioned $560 million purchase of 22 assets totaling 1.6 million rentable square feet of storage space in the greater New York metro market, estimated at more than $350 per square foot.
  • Sovran Self Storage (Uncle Bob's Self Storage ) - owns and/or operates more than 400 self-storage facilities encompassing over 20 million square feet. In the second half of 2011 Sovran acquired over $300 million in properties.

In addition to the REITs, there are several other large companies that have been very active in the self-storage industry, including but not limited to:

  • W.P Carey acquired the 42-property A-American Storage portfolio totaling 2.8 million square feet in California, Illinois, and Hawaii for $163.4 million. There were over 50 competing offers for the portfolio.
  • Strategic Storage Trust acquired $245 million in storage assets in 2011. Most recently, they acquired 12 properties in Georgia and Florida, totaling nearly one million square feet for $80 million.

Largely owning to economies of scale, large operators such as the REITS are better positioned to increase revenues through rent growth and expense control measures going forward than most local and regional operators. These large operators have ultra-sophisticated methods to grow the bottom line including dynamic pricing and revenue management systems, additional ancillary income opportunities, and scalable expense control measures such as group rate property insurance discounts and tax appeal processes.

One area where larger operators have a clear advantage is with respect to the changing advertising paradigm in our industry. It is no secret that internet advertising has become the primary component of a storage facility's advertising budget, replacing the yellow pages of old. The largest operators are better able to take advantage of internet marketing because of their ability to utilize highly-advanced methods, such as search engine optimization (SEO), and to design state of the art websites and mobile phone applications that are increasingly necessary to drive traffic to their locations.

Chicago based MJ Partners Real Estate Services compiles an excellent quarterly REIT overview. (3) Based on a review of their data for Third Quarter 2011, the implied cap rates of the REIT stock prices, based on common shares, ranged from 5.0% (Public Storage) to 7.7% (CubeSmart). As 2012 begins, all four of the self-storage REITs have strong balance sheets with large cash positions; this liquidity inherently makes them very attractive to lenders looking for a risk adverse lending position. As such, the cost of borrowing for REITs is currently very low, making it an attractive proposition.

Self-Storage REITs were very active in acquiring facilities nationwide in 2011. It is important to note that the self-storage industry is still highly fragmented, and in most markets the primary competition for the REITs consists of local and regional operators. The four REITS combined total approximately 3,700 of an estimated 50,000 storage facilities nationwide, or 7.4% of the total supply. The reality is that there is plenty of room for additional consolidation in the market. Look for REITs to continue to purchase in 2012 and beyond.

Limiting your Downside Risk

For owners of fully stabilized storage properties there is a limited ability to improve the property cash flow, thereby restricting the "upside" in these investments. More specifically, these operators are reliant upon periodic rent increases, resulting in a delicate struggle between retaining customers and raising rates. Expense controls can also be undertaken in an attempt to increase income, but this strategy has a finite return as fixed expenses are just that -fixed.

As a result, the investors in stabilized properties are often locked in to a narrow band return expectations on these investments. Moreover, the downside risk in these properties may more than offset the limited upside; consider for example the dramatic effect that a new competitor or disruption in the local economy could potentially have on occupancy, cash flow, and ultimately value.

Another major area of downside risk for owners of stabilized properties relates to inflation, rising interest rates, and the corresponding impact on cap rates. Inflation means rising interest rates, which by corollary also suggests that cap rates are increasing such that investors can maintain a healthy spread between interest rates and cap rates. Given that interest rates are currently among the lowest in history, one has to wonder how much lower cap rates can go. A European debt crisis, for example, could cause interest rates to increase here in the United States, with cap rates increasing accordingly. In fact, one might argue that the upside remaining from any additional compression in cap rates is more than offset by the risk that cap rates will in fact start to increase as soon as interest rates start to rise.

Clearly for some investors with a conservative mindset or those on a fixed income looking to preserve cash flow, increasing risk may not be the preferred strategy. But for those investors with an entrepreneurial mindset, now may be the ideal time to sell and redeploy the equity for the next investment, where more potential upside exists.

Opportunity to Redeploy Your Capital

It can be argued that local owners and operators have certain competitive advantages over the national REITs, which they can exploit to their benefit. For example, local operators may know their local market more intimately and therefore be better positioned to turn around a distressed asset in that market. By selling their stable asset, these entrepreneurial investors would be well positioned to redeploy that equity capital to profit on an investment with more upside return potential, such as a well located self-storage facility that is struggling to lease up due to factors other than lack of demand.

Granted, the risks may be higher, but then again, so are the returns. In order to purchase the value-add facility, storage owners can leverage the newfound equity and structure a bridge loan, enter into a joint venture, or if enough equity exists, buy a facility outright. By doing so, local storage owners are taking advantage of their market knowledge and maximizing their return on equity.

Conclusion

Despite the weak housing market, high unemployment, and a slumping economy, values for fully stabilized self-storage properties may be at or near their peak. Thanks to falling cap rates, access to capital that is becoming cheaper, and a market of increasingly-aggressive buyers, values are increasing.

If your storage facility is running at peak performance, for many, now is the time to sell. There are many large and well capitalized buyers in the market, such as the REITs, that are seeking core properties with stable and predictable cash flow that are accretive to their portfolios; many of these same investors are generally NOT as interested in value add investments with remaining lease-up, or those located in oversupplied markets. Local and regional operators with core stabilized assets can take advantage of higher return opportunities by selling to these aggressive buyers and focusing their attention on value-add investments that will create opportunities for increased cash flow and therefore, a higher return on investment.


[1] Domestic Self-Storage Market: A Cautiously Optimistic Outlook,

[2] http://www.insideselfstorage.com/news/2011/12/selfstorage-shines-as-topperforming-reit-sector-in-2011.aspx

[3] http://www.insideselfstorage.com/galleries/2011/11/selfstorage-real-estate-investment-trusts-financial-results-summary-3q-2011.aspx?pg=2

Mini-Storage Messenger March 2012

This article has been reprinted with permission from Mini-Storage Messenger.

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