Self-Storage REITs Feeling the Pinch

In self-storage markets, scattered signs hint of a slowdown. In cities such as Columbus, Ohio, customers can get the first month's rent for $1. Shares of the average self-storage REIT lost 3.4% in the first four months of 2007, according to the FTSE NAREIT Equity index. With housing sales falling, some investors worry that fewer homeowners will be storing lawnmowers and computers.

So is self-storage about to suffer a crash? Probably not. While the industry has little data on total vacancies, some markets clearly remain strong. Customers searching the Internet can find few discounts in cities such as San Diego and Boston. Overall, the national picture appears mixed, say industry experts.

Analysts feel few markets suffer from saturation. “Some companies report that demand is a bit weak, but others are showing decent same-store sales,” says John Sheehan, a securities analyst for brokerage A.G. Edwards & Sons in St. Louis.

Extra Space Storage Inc., a REIT in Salt Lake City, is typical of owners that are reporting so-so results. The company expects its net operating income to grow about 5% this year. That is down around a percentage point from the results of 2005 and 2006. “After two strong years, we are seeing a slight slowdown in 2007,” confirms Kent Christensen, executive vice president of Extra Space.

Prices stay flat

The yield on 10-year Treasuries rose from 4.5% in December 2006 to 5.1% this June, raising borrowing costs. Some analysts expected the interest-rate climb to lower the prices of self-storage facilities and boost cap rates (the initial yield in the first year based on the purchase price).

But cap rates have remained steady for about a year, says Marc Boorstein, a principal with MJ Partners Real Estate Services, a broker and consultant in Chicago. Boorstein reports cap rates of below 6% in strong markets, such as Southern California and Connecticut. In the Midwest, where growth is slower, cap rates are around 7%. Boorstein says that the prices are holding steady because big buyers are still bidding on self-storage properties.

The purchasers include investment banks, opportunity funds, and private equity. The institutional cash is a new force in the self-storage markets, says Boorstein. “A myriad of capital sources have discovered self-storage during the past two or three years,” he adds.

One of Boorstein's most notable transactions occurred in October when he served as broker for LifeStorage, a group of seven Chicago-area stores with 500,000 sq. ft. and 3,853 rental units. A private Orlando group, backed by UK investors, paid $52 million for the acquisition. In the past, such big investors would only buy finished projects with stable tenant rolls, says Boorstein. But in this case, the properties were mostly new structures with few tenants, and two facilities were still under construction.

The investors bought the unfinished portfolio, hoping to expand their holdings quickly and perhaps go public. Boorstein says that the deal indicates how confident lenders and investors now feel about self-storage. “This is the first deal we ever sold where there was very little income in place,” says Boorstein. “The lending community saw the potential in these properties, and they financed the deal.”

Resilient in hard times

Institutions traditionally considered self-storage a mom and pop business. But that attitude has changed as public REITs have emerged in the past decade, and the industry has shown its ability to produce steady returns in soft periods. In the recession years of 2001 and 2002, revenues declined for many offices and warehouses owners.

But self-storage properties proved more resilient. Extra Space Storage reported annual revenue gains of more than 1% during the weak years. “During downturns, we aren't hurt as much as other sectors,” says Christensen of Extra Space Storage.

Christensen concedes that some self-storage markets do become overbuilt periodically. About five years ago, he says, Extra Space opened four facilities in Long Island, N.Y. Around the same time, developers built another dozen properties. The market became overbuilt, and Extra Space spent four years filling its vacancies. Most years, however, properties are built and fill up, he says.

The storage industry is relatively steady because of its broad customer base. While an office or warehouse may depend on one or two big clients, self-storage facilities have dozens of customers. About one-third of customers are typically small business people, says Boorstein. In recessions, space users have less need to store documents and equipment.

But about two-thirds of self-storage customers are private individuals. The group includes college students and military personnel, as well as people going through life changes, such as divorces, deaths, and job transfers. Many of these individual tenants need to use self-storage — no matter how the economy is faring.

Dramatic growth

The self-storage industry has expanded steadily in recent decades, growing from 289 million sq. ft. in 1984 to 2.2 billion sq. ft. in the first quarter of 2007, according to the Self Storage Association, a trade group in Alexandria, Va. Nearly one in 10 U.S. households will use self-storage this year, up from one in 17 in 1995.

The biggest portfolios are owned by four public REITs — Extra Space Storage, Public Storage, Sovran Self Storage Inc., and U-Store-It-Trust. Of the 51,000 facilities in the U.S., 21,000 are held by small entrepreneurs who own one facility, reports the association.

Public REITs only own about 3,000 facilities. Public Storage in Glendale, Calif., ranks as the largest owner in the country with 2,000 properties. “It is uncommon to see portfolios of more than 50 properties,” says Sheehan of A.G. Edwards. “Most owners have no more than 20.”

While the industry has been consolidating, plenty of owners are slow to sell. Part of the reason for their reluctance, says Sheehan, is that many of the businesses are extremely profitable. Operating margins — rental income minus operating expenses — can be higher than 60%. Profits are rich because expenses are low.

It only takes two or three people to run a facility. Maintenance costs are limited. Heating and cooling bills are much lower than what apartment owners face. Many facilities can break even with 60% occupancy, and it is not uncommon for owners to fill more than 85% of their units.

“The mom and pop owners are not stupid,” says Sheehan. “The industry will continue to consolidate, but there will be a significant percentage of the business that is owned by small players.”

Raising the bar on quality

Even if local operators decide to sell, institutions do not necessarily want to buy the typical store. Many of the properties in secondary markets are small with rough facilities. A small-town project might be less than 50,000 sq. ft. with a gravel driveway and a tiny front office. Institutional investors insist on properties that are typically 50,000 sq. ft. to 100,000 sq. ft. with computerized security systems.

Such state-of-the-art facilities have only begun appearing in the last 10 years. Far from being eyesores, the new properties resemble modest office buildings. For example, Extra Space Storage opened a three-story property in Chicago last year that has spacious windows along the front. Institutions see such properties as solid investments that can last for years.

Customers coming to the new facilities typically enter 1,000 sq. ft. offices that have comfortable furniture and provide free coffee. Desk clerks offer a variety of services. For example, a small business can have UPS packages shipped to the facility and placed into the customer's storage space. To handle big loads, Public Storage will truck a container box to the customer's home for loading and then have it trucked to the storage facility.

Class-A buildings are climate controlled, with temperatures ranging from 55 to 75 degrees so that documents don't curl. “Lawyers want to store records, and pharmaceutical reps keep their samples in storage,” says Steve Hryszko, vice president and national director of self-storage for brokerage CB Richard Ellis. “Customers are willing to pay extra for a facility that can protect their things.”

Self-storage facilities must maintain tight security, emphasizes Leigh Robinson, who owns two 500-unit properties in Fairfield and Woodland, Calif. Robinson says that tenants have been known to rob other tenants when there is poor security. There are also cases of tenants operating drug laboratories from their rented space.

Robinson recommends running a fence around the facility. That basic defense should be reinforced with cameras and laser systems that can detect any intruders. A full security system costs about $14,000. “If you don't have a solid security system, customers will go somewhere else,” he says.

In the past, self-storage facilities were often hidden away in industrial zones. Lately the new Class-A properties are built along main highways and strip shopping centers. Some facilities are mixed uses, including retail space and self-storage. Simon Property Group, the Indianapolis-based mall REIT, is planning to build 20 self-storage facilities.

“Some of the self-storage outlets are going inside the Simon malls, and some of the facilities will be built in lots next to the malls,” says Boorstein. “For a mall owner, self-storage may fill up space that hasn't leased well in the past.”

Economies of scale

Though most developments and acquisitions are small, Public Storage managed a major leap in size when it acquired Shurgard Storage Centers for $5.5 billion in August 2006. The acquirer gained 487 domestic properties in 21 states, including stores in Los Angeles, Chicago, and New York. Public Storage considers the properties high quality because they are located in densely populated areas where it is difficult for competitors to build.

For the purchaser, the merger offered the chance to benefit from economies of scale, says Clem Tang, vice president of investor relations for Public Storage. Tang says that many of the acquired properties were in markets where Public Storage already operated. For example, Public Storage owned about 40 properties in Seattle before the deal and 80 afterwards.

The merger achieved some of its most important efficiencies because of the use of Public Storage's computerized call center. The computers track vacancies and prices in real time. Customers anywhere in the country can phone or use the Internet to instantly learn what units have vacancies. Phone representatives can provide advice on the size of units that a caller should take.

The system also makes it possible for the company to set optimal prices. If a location has too many vacancies, the software can suggest solutions, such as lowering prices or offering discounts. In cities with low vacancy rates, the system can suggest raising prices.

The Public Storage computer system has already helped to boost the former Shurgard units, says Tang of Public Storage. At the time of the merger, Shurgard recorded an occupancy rate of 84% compared with 91% for the Public Storage properties.

By June 2007, the Shurgard units had topped 88% occupancy. “The day after the deal closed, we changed the signs and extended the phone system to cover the new properties,” says Tang.

Most of the public companies are actively seeking to pick up local properties one at a time, instead of developing from scratch. The exception is Extra Space, which expects to open 15 to 17 new properties in 2007.

Developing self-storage properties is a lengthy process, says Christensen of Extra Space. The difficulties start when a company tries to obtain local permits. Many government officials discourage construction of self-storage properties, which may be viewed as unsightly and poor sources of employment.

Unlike retailers, the storage properties produce limited sales taxes. Overcoming government objections and starting construction often takes two years. Then building the property may take another year. After that, it typically takes two to four years to fill a new property, says Christensen. “Most public companies are not patient enough to wait six years before they see any value created,” he says.

Opportunities overseas

Some U.S. investors are seeking to expand in Europe, where the self-storage is just beginning to develop. “In Europe, the industry is about 10% of the size that it is in the U.S.,” says Laine Kenan, executive director of Arcapita Inc., an Atlanta-based private-equity firm that is partnering with developers in Europe. “Many European consumers do not yet understand how to use self-storage facilities.”

So far, the European industry is based in the UK, Scandinavia, Germany, and France. One of the leaders is Big Yellow Group PLC, a UK REIT, which owns 65 stores with 4.1 million sq. ft. The biggest U.S.-based owner abroad is Public Storage, which acquired 160 European units in its purchase last year of Shurgard. Many of the European stores are American-style, Class-A properties, according to Kenan.

In the U.S., the industry can continue expanding as the population grows and demand for space increases, says Hryszko of CB Richard Ellis. “Americans by nature are hoarders. They want the luxury of having extra space.”

Stan Luxenberg is a New York-based writer.

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