The New Wave of Joint Ventures: Will They Pave The Way For Future Storage Development?

June, 2014

The economic downturn caused self-storage occupancies and rental rates to dip, forced a number of owners into foreclosure, and put the brakes on new self-storage development. As the economy continues to recover, self-storage has experienced a turnaround with occupancies and rates rising to historic levels in many areas of the country. There is also renewed investor interest in the sector; especially considering how well storage fared during the recession. That caught the attention of Wall Street and other investors. Whether they are looking for a steady source of income or greater returns than other investment vehicles offer, capital is starting to flow into this industry in a big way. That has given rise to a new wave of joint ventures that's bringing fresh capital to an industry some investors consider a rising star among asset classes. These joint ventures are allowing some operators to expand their footprints and newbies to enter a promising real estate sector. Joint ventures may also jump-start a new era of development that will be needed to meet marketplace demand in the years to come.

Accelerating The Pace

Industry experts report that the number of joint ventures announced or in the talking stages is on an upward curve. "I think it's tremendously gone up in the last two to three years," says Mike Parham, president of Noah's Ark Development in Bulverde, Texas. "I've got more business now than I had in last five years combined." Parham credits most of this activity to new investors coming into the industry. "The quality of people that are joint venturing now is a lot better than it's ever been," he says. JVs can take many forms. The self-storage Real Estate Investment Trusts (REITs) have used them for years to buy portfolios of properties that may lie outside the parameters of their balance sheets. For example, regional operators who want to grow beyond their immediate borders but still want a safety net might form a joint venture with a REIT.

"Often, a regional group sees an opportunity in a market where they have deep knowledge and would like to leverage their capital by JV-ing with an additional equity source," says Anne Coolidge Taylor, man- aging director of New York-based W.P. Carey. "For owners of existing businesses, JV opportunities allow them to partially monetize their assets but continue to grow and develop their business."

A joint venture allows participating par- ties to leverage equity. The operating partner benefits from branding and economies of scale by investing a portion of the equity. The REITs carry some of the equity to the transaction, while the joint venture partners bring the balance.

"If we see properties that are more yield oriented than growth oriented, we'd put those in a joint venture, because there are investors who like that type of thing," says Sovran Self Storage CEO David Rogers. "They like the idea that this may not grow tremendously in appreciation, but in good times and bad, it's going to be a secure source of cash flow."

Six years ago, Sovran formed a joint venture with Heitman LLC to purchase 25 properties. The facilities carried more than $80 million of debt, which the REIT did not want to hold on its balance sheets.

"We formed that joint venture because we didn't want to encumber our balance sheet with mortgage debt," Rogers explains. "We have only long-term, fixed- rate, unsecured debt, so we keep it very lean. We did a deal where we re-branded all the stores with our trade name, Uncle Bob's, and managed the properties and call center."

In 2011, Sovran had its eye on a portfolio of 19 properties in New Jersey and Pennsylvania and formed a JV to purchase the facilities. "We didn't see a lot of upside on those stores but they were Class A, high quality stores," Rogers notes. "We felt it would be a detriment to our company balance sheet even though we liked the quality of assets and the market."

Sovran formed a joint venture with an affiliate of Heitman, which contributed 85 percent of the equity to the JV with Sovran providing 15 percent.

"We didn't see a lot of upside in those properties but we realized they were almost bond-like in their capacity to generate cash flow in good times and bad," Rogers says. "As it turns out, we were able to grow them considerably. We didn't realize at the time the power of our platforms-our Web-based marketing, call center, and revenue management program. It's been a homerun for every- body involved, especially the joint venture partner."

Driving New Development

REIT executives, storage developers, and other industry experts acknowledge that a new wave of development is coming to self-storage. The last time that happened at the turn of the new century, developers competed for elbowroom in the market- place, which led to an over-supply of product in many cities.

After getting burned, developers, bankers, and investors have become much more cautious. Some observers think there is pent-up demand that's building for new buildings. In this new era of financial responsibility, joint ventures could be the mechanism that drives a building boom.

"Prices are rising, the market is very competitive, and there hasn't been much new development," says Coolidge Taylor. "People are looking to develop, and a joint venture offers an attractive vehicle for development. There are plenty of developers out there who are looking for equity partners and vice versa."

Many distressed properties are now off the market and under new ownership. That has helped to stabilize values in some markets. Add to that a steady population increase along with the robust growth of occupancies nationwide, and that's a formula for new demand for space.

"Because there's a buzz about development, people are excited to put money to work and start building stores if they feel there's a good return in the end," says Shawn Hill, principal at the BSC Group in Chicago. "If you can get a desirable location and put up a store and have it make sense, then you need to start looking at building when there is demand in the market."

Hill estimates there are between 100 and 200 new facilities coming out of the ground this year, which would not even be enough to satisfy the demand of population growth alone.

"For the first time in a long time, there is a case to be made in certain markets that there is demand to build stores," Hill says. "You need to have a track record; you need to have fundamentals; and there needs to be a good site. When you have an experienced developer in a market where there is demand and they've got zoning and capital to build, you can get loans. There is a viable take-out strategy whether you continue to operate the property either by yourself or in a joint venture with a major operator."

JV investors will need to have patience before they see a return on a new project. The property must be zoned properly and win community support. Then the facility must be built and marketed before units begin filling. It's a process than can take from three to five years.

REITs are better positioned to make portfolio acquisitions where the return is immediate, rather than financing new development that will be years in the making. That's where joint ventures come into play. The REITs are interested in new development, but on a limited scale.

"We've all been talking to local guys who have local knowledge and shovel- ready parcels, and you'll see a little of that but it won't be on a grand scale," Rogers says. "There might be joint ventures that might be one-off or two-off deals with a guy who has expertise in his home market. We have small ones where we'll come in and put a little money in and manage the stores and the developer builds it."

Rogers says Sovran is partnering with local developers in Chicago, Atlanta, and Chattanooga, Tenn., to build new facilities. Sovran may take up to a 15 percent stake in the deal, although it may not be a true joint venture.

Extra Space, which shuttered its development program during the recession, along with CubeSmart reportedly are talking with a number of developers around the country about building new stores.

"Sovran and Extra Space do not have development platforms, so I think they are looking to a joint venture model or partner with qualified builders," Hill says. "It's a good marriage because in many cases, those people are builders and not operators. The developer takes the risk to get a loan. Developers are used to pre-construction risk and building risk. What they don't like is operations risk."

The REITs' strategy would be to man- age the facilities with a vision of acquiring those stores down the road. "We go into a joint venture program and our third-party programs with the idea that we only take on those properties that we'd like to eventually own," Rogers confirms.

Once the store is open and doing business, a REIT may move quickly to acquire the property if it's well located and considered a high quality asset. "They may attempt to purchase the asset when it's largely vacant under the theory that they can buy it at a discount to what they would have to pay if they wait for the store to be fully leased," Hill says.

Fueling Higher Returns

Local, regional, and national privately held companies hold tens of millions of dollars of equity looking for a home, and self- storage represents the best landing spot for many investors. For example, a company may have divested itself of apartment buildings or other properties and is now looking to enter the storage space.

Some investors see the yield on storage as a better option than bonds, so they may participate in a JV to buy an existing business. Others who are patient enough to wait several years for facilities to be developed may reap even higher returns. "If I develop something, they're going to have to wait but they're going to get a 20 to 30 percent return on their money in five years," Parham says.

To get the project off the ground, the developer uses loan proceeds and investor funds to build the facility. After the property begins to lease up, the loan can be refinanced and the investors paid. "After I get to stable occupancy of close to 90 percent, at that point I refinance it because the project has a value that's a lot more than our loan and our equity," Parham says. "A lot of times, you're get- ting half to all of our equity back and their return on investment doubles."

Rather than the shotgun approach of a decade ago, self-storage development will be much more focused on areas where demand is evident. Hill says development will take place in cities with "strong core markets, where people have an eye on fundamentals." These include Miami, New York, Chicago, Los Angeles, and some Texas markets such as Houston.

Noah's Ark is getting interest from states that have seen an economic rebound in real estate and jobs. These include Texas, Oklahoma, Nevada, and Florida. "A lot of that has to do with their location and how financially sound that is and what's going on with their economy," Parham says, adding that he's now talking to investors who dropped out of the storage market several years ago. "Some of the people I've done business with six years ago are back in the market," he says.

JV Candidates

Joint venture partners come in all shapes and sizes, but developers or operators with scale are better candidates. "Usually they've got a bigger regional footprint, they've got a track record of being successful, and want to take it to the next level," Hill says. "They have to meet reporting requirements, and they have to be willing to provide the joint venture partner with a certain level of control. That favors somebody with a more robust platform than a small operator."

Private equity companies may seek to enter the storage industry through an established operator to reduce risk. "It is hard for institutions to get into the market in scale and one way to do that is through a joint venture," Coolidge Taylor says. "If an institution doesn't have an operating platform, a joint venture partner might have one in place, offering a lower risk alternative to building one from scratch."

Parham prefers limited partnerships for his Noah's Ark joint ventures because they provide some tax benefits and flexibility in the states where they operate. Usually, no more than four partners make up his JVs.

"I sign on the loan and the investors put up 20 or 25 percent of the equity," Parham says. "After that third or fourth year after I refinance, I'm off the debt side of it and they've got their equity back. At the end of the fifth year, most of the time I've had a 10 to 12 percent increase in rents and my operating expenses have gone up 4 to 5 percent, so I get a 6 to 7 percent difference in income versus expenses. My return kept going up, and at the same time, I've paid down the debt."

One Noah's Ark joint venture is a 70,000-square-foot facility in the Austin area that opened in late 2012 and reached 49 percent occupancy after the first year. Three partners invested $1.6 million in the $6 million project and the balance was financed through a note that Parham took out. The investors were new to self-storage and Parham says they were looking at better returns than the bond market was yielding.

"If you look at their entire portfolios, they probably have a certain percentage of it completely secured and making 4 to 7 per- cent and they were looking for something else that would make a lot higher," Parham says. "It's projected that by the third year, they're making 20 percent on their money."

Investors who put money into joint ventures with developers have a similar mentality to stockholders who are willing to take risks in exchange for better returns over several years. Other JVs that invest in a stabilized project appeal to investors who don't want to take the development risk and are content with bond-like returns.

"Our industry is being recognized by Wall Street. Now they're seeing it as a viable business," Parham says. "You're going to see a lot of different players during the next year. There are a lot of people getting into this industry for the first time that you would be surprised about."

There is plenty of equity sitting on the sidelines and self-storage is attracting a lot of attention. These funds could find their way into self-storage joint ventures down the road.

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

Mini-Storage Messenger June 2014

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