Buying $elf-$torage: When to Love It and When to Leave It Alone

September, 2014

Buying the right self-storage property can be one of the wisest investments out there-as evidenced by current investor interest in the segment. Without a better invest- ment type to funnel their proceeds into, owners are holding on to self-storage, and the shortage makes it an even more sought-after product type. Still, overpaying or buying the wrong property can be costly mistakes. Sure, you want to love it, but hidden problems could affect your return on investment.

Fortunately, there are experts in the industry whose jobs are to help you find a winner and avoid making a mistake. Mini-Storage Messenger asked some of the industry's leading consultants how to find properties that aren't widely advertised, how to compete with other buyers, and how to find hidden negatives as well as hidden gems. They share their general wisdom on buying self- storage and some useful guidelines for when to love it and when to leave it alone.

Looking For Love

Self-storage buyers would all like to find that gem of a property that may not be as visible to other investors, but those properties are difficult to find in a market where there are more buyers than sellers. However, a little legwork can pay off when searching for potential self-storage deals.

"Look for off-market deals by physically canvassing the market and trying to engage in direct communication with the owner," suggests Shawn R. Hill, principal at Chicago-based The BSC Group, LLC. He also recommends checking offbeat sources such as LoopNet or smaller independent investment sales brokerage houses that are not storage specialists. "They sometimes get list- ings that aren't widely shopped," Hill says.

Aaron Swerdlin, executive managing director for Houston- based Newmark Grubb Knight Frank, agrees with this tactic. "The key is to find the deal that's not for sale and try to get in front of them before they become sellers" he says. Still, both agree that you're not going to convince anyone who doesn't want to sell, to sell.

"Candidly, if you're trying to find deals, you have to go to the deals direct," says Steve Mellon, managing director of the National Self Storage Team for Houston-based Jones Lang LaSalle. "But if a broker is involved, you have to find out who the broker bringing the deal really represents. If they represent the seller, they may have a direct deal but they've shown it to three or four other buyers. It's a fine line." The question to ask is whether the broker represents you or the seller.

According to Hill, lenders are another option when searching for a property. "Lenders with distressed debt that are looking to sell notes or foreclosed assets can also be a good resource for those with patience and the expertise to work through those situations," he says.

Mellon says the main reason current owners are reluctant to sell is a lack of reinvestment opportunities and the resulting tax consequences. "What do you do with the money? That's our big- gest hurdle to getting someone to sell," he says. "The group that figures out how to alleviate the tax consequences to the seller can be miles ahead of everyone else." The problem is, figuring that out can be complicated.

There are still owners out there who are at least considering a sale for various reasons. If an owner is vacillating, how can you tell they really want to sell? "If they keep talking to you," Mellon says. "If a guy says he doesn't want to sell and never calls you back, he doesn't want to sell. But if he says he doesn't want to sell but keeps calling you and saying he wants to go to lunch, that's a good sign."

In this situation, Mellon recommends keeping the conversation going for as long as it takes. "'Can you get me $18 million?' he asks. You say, 'I'm not sure.' You never say no," he explains. "You just keep talking to them."

Hill says deferred maintenance can be a sign that the current owner is distracted or distressed and might entertain a sale. "Also, search the tax records," he recommends. "If you can identify a property that is behind on taxes, it can indicate that the property might need to trade."

Buying Self-Storage

Whatever the reason, a good time to sell eventually comes along for most owners. Mike Mele, first vice president of invest- ments and senior director of the National Self Storage Group for Tampa, Fla.-based Marcus & Millichap, says his company has a program for their clients in which they analyze properties and the market every six months to help them determine the right time to sell.

As Swerdlin explains, selling is cyclical. "You always have people coming to the end of their five- to seven-year hold," he says. "Developers who have developed four or five properties and it's time to sell one or two to cycle a little bit of capital."

Swerdlin says the market for large trans- actions is different-and much greater than it was 10 years ago. "I almost think there's two markets-the $100 million to $200 million-plus market and then the $100 million or less market," he says. "They act very different and the opportunities are much greater in the bigger market. Last year we did over $2 billion worth of transactions as an industry-50 to 60 percent bigger than the highest year before that." Yet, he says if you look at the 10-year average, it was significantly below average in the number of transactions. "It means that a lot of big deals have gone down but the number of transactions have gone down also."

Why the lack of smaller sales? It goes back to the problem of sellers not knowing what to do with the capital when they sell. "Those that happen were planned for a while-you've reached that point of their disposition horizon," says Swerdlin. He believes the fact that an aggressive market didn't draw out sellers of one to three prop- erties says a lot, including the fact that no one's really struggling.

In such a tight market, then, finding a property to love may mean revising your wish list. "Everyone wants a class B, mis- managed property in a class A market and location-a B+ property located at Main and Main that's 50 percent occupied, managed by Mom and Pop, and has great demographics," Mellon says. That's the hidden gem everyone is looking for, but he says opportunity fund buyers can find a B- property, put money into it and turn it into a B+, and then turn it around.

"Those are the deals that are the real hidden gems," Mellon says "It's not that people aren't looking for them-they're not paying full value for them because it's risky." He says everyone sees the oppor- tunity but being able to put the money into rehabbing the property is another matter.

It's (Almost) Always Location

All self-storage operators agree that location is paramount when making a buying decision. "You can upgrade a 'C' property in an 'A' location, but you can't change the location of an 'A' property in a 'C location," Hill says. "Most of the people who got burned in '97, '08 and '09 missed it on location," Mellon recalls. "Houses that were sup- posed to be built got stopped, so they had built a self-storage facility in the middle of nowhere." This is where he still sees the biggest mistakes. "Even the micro- location," he says. "If you're going to build on a side street where no one sees you, you'd better have really low upply and high demand. You can hide your sins a lot better if you have a great location."

Still, location isn't the only factor to consider. The ooverall market is an important consideration as well. "Is it a market with stable housing? You don't want extremes," Swerdlin says. "Anytime you're depending on outsized growth, you're setting yourself up for disappointment. Core stable housing and employment growth in the single or low double digits are best." He admits that there are opportunities to make a lot of money in a fast-growing market; however, he says, "If you want stable low risk, go to the urban core. When you're urban, location is important but it's a different kind of location."

Swerdlin explains that in the suburbs you have to be visible, but an urban location is more about the convenience of the location. People don't necessarily have to be driving by your location every day because they go to their mobile devices when they need storage. "They could never have seen you before," Swerdlin says, "but as long as you're easy to get to in their small core urban area, it's a lot less important to have that drive-by recognition that's critical in suburban areas."

Mele says the property's age, construction type and deferred maintenance are also important considerations, although many things are worth fixing at the right price. "It all boils down to the numbers," he says, "but otherwise, location is still key." He believes generation one and generation two properties that are well located and well priced are sometimes overlooked opportunities. With an infusion of capital, low occupancy and deferred maintenance are problems that can be overcome.

Hill says properties that have an underwhelming Internet presence can also present an opportunity. And finally, financing can be a reason to love a particular deal. "A real good, long-term debt package can help increase cash flow substantially and insulate the property from interest rate risk over the investment time horizon," Hill says, advising buyers to determine if the property features and location will allow it to qualify for some of the ultra-competitive financing packages that are out there.

In fact, Hill believes properties wish distressed debt can have potential. "Properties that are tangled up with lenders or in a BK situation can be tricky," he says, "but often presents a great opportunity for those investors who have the savvy figure to figure it out and create a structure or mechanism to work out the deal."

Property Challenges

Many problems discovered in the due diligence stage can be overcome. But sometimes it's best for a buyer to walk away because a property just doesn't meet his or her investment needs. Mellon says a purchase decision should largely depend on the buyer's motivation.

"When we talk to new capital getting into the market do they need cash flow? An investment makes X return? Then, they're looking for properties that are nearly stabilized and making money," he says. "Others are looking for the home run- a property that has issues and they aren't worried about the cash flow on day one. They'll take a low return at first, turn the property around, and make a tremendous amount of return." The third group, Mellon says, are the old guard operators who have started developing.

Swerdlin agrees you should be extremely disciplined about what you want out of the acquisitions you're making. "It's critical to figure it out quickly," he says. "Maybe the last four months, they've been collect- ing revenue you assumed was earned as collected but it turns out it was just col- lected and will be earned over the next few months. So, the cash flow is not as strong as you had underwritten. You have to be very disciplined about the returns you think you need with the risk you're taking."

Especially important, he says, is to let the seller know as soon as possible. "You go to the seller and say, 'Look, I'm not looking for a re-trade or to reduce the price. After further due diligence, though, what I thought I had bargained for isn't what I hoped to get-so, I'm out.'" Swerdlin says. "It goes back to reputation. It's best to just walk away." Of course, if the seller wants to keep bargaining after you uncover a risk, that's different. "Short of an environmental issue, everything at the end of the day comes back to economics," he says.

Mellon also believes it all comes down to the numbers. "There's nothing that money can't fix," he says."If the deal is good at $4 million but then there's a big environmental problem-well, I can't buy it for $4 million but I can buy it for $2 million." This situation, he emphasizes, is only for real issues that were unknown upfront. It's not the same tactic of intentionally going in high and then finding excuses to knock down the price. "You can only do that once, and then you get a bad reputation," Mellon says.

Tying up a property knowing you're going to start hacking away at the price and negotiating things that were already apparent is a bad strategy. "It's called a re-trade, and it's not good," Mellon says. "You can do it once, and then when it gets out there, you won't be shown deals." The best way to avoid even the appearance of being a re-trader is through comprehensive due diligence.

Issues discovered during due diligence can change the attractiveness of a deal significantly-especially environmental and tax problems. "Tax consequences can be tricky," Hill says. "It's very important to understand what the long-term tax implica- tions are upon sale."

Mellon agrees. "Understanding the real estate taxes is the most important thing," he says. "Everything else you can fix. You can fix a roof leak or bad management, but if you don't understand the real estate taxes, that could be a big 'uh-oh.'" A tax consultant or knowledgeable broker can help you understand any unfavorable tax consequences.

Due Diligence Requirements

A good investment decision begins with thorough due diligence. Shawn R. Hill, principal of The BSC Group, LLC recommends obtaining the following information:

  • Lease files. The lease files for all tenants, including the leases, amendments, guaranties, and any letter agreements and assignments in effect
  • Maintenance records and warranties. Maintenance work orders for the 12 months preceding the effective date of the agreement and warranties, if any, on roofs, air conditioning units, fixtures and equipment
  • Building plans and specifications relating to the property
  • Licenses, permits, and certificates of occupancy
  • Service Contracts. A list, together with copies of service, supply, equipment rental, and other service contracts and license agreements related to the operation of the property
  • Copies of existing ALTA survey and site plan
  • Trailing 12-month financial statement broken out by month, certified
  • Current rent roll
  • Tax returns for the previous two years (minimum)
  • Copy of current Insurance Certificate
  • Details and list of all insurance claims, past or present
  • History of capital expenditures (previous property condition report will work as well)
  • Building and site plans, construction drawings
  • Engineering and construction reports with warranties and guarantees
  • Competitive market study
  • Appraisal or narrative sections
  • Government inspection reports
  • Licenses and permits
  • Certificates of occupancy
  • Evidence of pending or threatened litigation
  • Flood certificate (if applicable)

Source: The BSC Group, LLC

Another challenge may be new construction in the market. You may buy a property and then discover someone is building a new one next door. Mellon says that's sometimes difficult to determine. The best thing you can do is talk to brokers, community officials, and architects to determine if any new projects are slated in the area.

Swerdlin, however, believes new com- petition shouldn't pose a huge problem. "I just don't believe one new competitor will sink every property around it," he says. "Every property someone's going to buy in a market should have enough capacity for another 50,000 square feet. If a property is so susceptible to decline that it can't handle one new competitor, it's not a property you should buy anyway."

In fact, Swerdlin believes it's difficult to create a scenario where a property goes backward unless you absolutely inundate it with competition. "The greatest risk the product type has is getting back into the development mindset of 2006 and 2007," he says. "Fortunately, although you hear a lot about development going on, you still have to have a bank that's willing to lend and real cash in the deal."

A borrower the bank is happy with, who has enough cash in the deal that it hurts to lose it, will be less likely to build irre- sponsibly. "We'll see some development that probably shouldn't be built but, at least today, the safeguards in place should minimize the catastrophic implications for development," Swerdlin says.

Of course, there are problems to look for such as poor tenants who are kept around by managers or an owner who has 30 units rented to his close friends and family. Swerdlin says to be wary of "three months up front, then three months free" deals that skew the numbers. "If you're counting on that $60,000 per month that is going to end," he says, "that's not going to work." The best thing for the seller as well as for the buyer is thorough due diligence.

Wooing A Seller

In a seller's market, buyers find themselves competing for deals. Few owners are sell- ing and when they do, they can afford to be selective in choosing a buyer. "If you're in it, you're not trying to exit it, and if you're not in it, it's hard to get in," Swerdlin says. "And there are more people trying to get in than get out."

We've mentioned one key to overcoming this problem-to find a property that's not for sale and try to establish a relationship with the owners before they become sellers. You're not going to convince anyone to sell who isn't ready, but showing up late won't cut it in this market "You have groups that have just decided within the last several months that they want to make an investment in the product type and have never considered it before," Swerdlin explains. "Groups like that are behind the eight ball because there are innumerable buyers who have been trying to buy for a long time, and they have a head start establishing relationships and establish- ing a reputation within the industry."

These days, you can have money, you can have access to debt, and you can understand the product type, but if you haven't closed a deal recently, it's a risk to go with you since there's no shortage of people who have. "If I'm advising a seller, all things being equal I'm going with the group that has the most experience," Swerdlin says. The more transactions you've done, the more attractive you lookto sellers.

What else makes a buyer look good in a competitive market? "Full control of the buy- ing process," Swerdlin says. In other words, the seller or broker likes it when the one or two people they're dealing with have 100 percent discretion, and they don't have third- party venture partners whose committee has to approve a deal or who have to go outside their own organization for approval. "That is absolutely number one," says Swerdlin.

Other advice? Hill says to remain objec- tive. "Don't become emotional about a deal and fall in love with it," he says. "It can impair your judgment."

Swerdlin agrees. "Understand what it is you're trying to accomplish and don't stray away from it," he says. "Stick with your game plan and don't jump ship until you're abso- lutely convinced it's the wrong strategy." He advices a long-term approach and lots of patience. There are definitely more buyers than sellers, and nothing replaces a few years of getting your message to the market. "If you've done that," Swerdlin says, "nobody can just show up and get in front of the reputation you've built."

Tammy LeRoy is Editor of Mini-Storage Messenger.

Mini-Storage Messenger September 2014

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

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