Real Estate

6 Ways to Get Burned by Investing in Self-Storage


Self-Storage is HOT!

This means it’s a great time to get BURNED!

Huh?

Let me explain. I’m the author of BP’s newest real estate investing book, Storing Up Profits – Capitalize on America’s Obsession with STUFF by Investing in Self-Storage. And my most recent BP post reported on the crazy popularity of self-storage since the pandemic hit and why.

Investors of all types…residential, commercial, institutional, and newbies, are jumping in. Like I said…

It’s a great time to get burned.

Why?

Because buying popular assets at inflated prices can be a recipe for failure. When you buy near the top of the cycle, you may pay too much. And you may not be able to create the income and value improvements you hope for. Then you may find yourself underwater in the time of a correction.

Investing billionaire Howard Marks has a great book called Mastering the Market Cycle. I highly recommend it for every real estate investor. Marks explains why there will always be a cycle and why a downturn is always imminent. And he tells readers why buying a popular asset near the top is the most crucial time to pay a low price – not a high one. Which, of course, is precisely when the masses are paying a premium.

Is it even possible to get a good deal when prices are at unprecedented levels? Yes. I’ve written about this before in several posts. The key is finding assets with hidden intrinsic value.

I really don’t want you to get burned. So my goal in this post is to explain five dark sides of the self-storage business. These are potential downsides of the business you should look out for in your own thinking and in a potential investment.

My goal is that you aren’t blinded by the mad rush into storage and end up asking for your money back on my book. ? Or worse.

Risk #1: The top risk in self-storage: unexpected competition

Is your storage facility in a popular location? Is it in a major population center experiencing healthy growth? Is it located on a main road with high traffic counts? If so, you may be well-situated to own a profitable facility. These are some of the main factors for success I outline in my book.

But you may also be situated to attract competition. National players like Public Storage, Life Storage, and CubeSmart are also looking for locations like this. And they have the resources to build a new and nicer facility nearby. They have topflight marketing. And they have deep pockets that allow them to undercut their competitors if they want to. If they can do this long enough, they can strangle your profits then offer you a low price to buy you out.

The top risk in the self-storage business is new competition. This risk is especially acute during the time of lease-up. If your facility is still on the path from zero to stabilized, and a competitor pops up, it could spell trouble. It could result in lower occupancy, lower rents, and higher concessions. And even when your physical occupancy stabilizes, your economic occupancy, the real driver of your profits and value, could still be in the tank.

One of the most nail-biting experiences in our firm’s recent investment history happened just like this. Before we launched a diversified fund, we invested in a pair of self-storage facilities in an exploding area of Florida. These assets are in one of the fastest-growing planned communities in America, with about 29,000 new housing units constructed or planned.

How could we lose?

Well, about the time of the acquisition, we learned that not one, but two major national developers were building facilities nearby. And since our facility was still in the lease-up phase, we got nervous.

Our fears played out. Our facility took much longer than we expected to lease-up. And our operating partner had to offer concessions to attract tenants. The cash flow from operations was a trickle for over two years of ownership.

It has a happy ending. Because all three assets have stabilized, and occupancy is now north of 90%. And this asset should be sold within weeks, giving investors well north of a 60%+ return on investment in about three years.

This is one of the benefits of the self-storage business. In the right location, with the right operator and marketing team/strategy, almost every new facility eventually leases up.

Todd Allen is the CEO of Reliant Real Estate Management. He has decades of experience in the self-storage realm. Todd and I discussed this issue this week and he said…

“New competition coming into a market is the single most significant threat to a self-storage lease-up. This new competition can undercut your market rental rate structure, pushing your economic breakeven point further into the future, affecting current and future return scenarios. For the most part, you can mitigate this threat by completing a thorough market analysis of the current competitive set and any future development contemplated in the markets.”

How could you combat this issue?

One strategy is to invest in an out-of-the-way facility. This is an asset that is unlikely to have a national competitor move in down the street.

Like the time we invested in a Texas storage facility in a small town of 12,000 a few years ago. We didn’t expect any competition, and there wasn’t any. We did expect a poorly run, poorly marketed facility with lots of potential.

We were right. Our operating partner acquired the facility for $2.4 million in early 2019. He sold it less than two years later for $4.6 million, producing an IRR of over 80%. You can certainly see returns like this in bigger markets, but this one had the added benefit of safety through the lack of competition.

Risk #2: Under-capitalization during lease-up

Especially in a lease-up scenario, it is critical that you over-capitalize the asset enough to assure you can safely maintain positive cash flow during unexpected (and some predictable) situations.

For example, what about the construction project delayed by Covid, lack of labor availability, or a slowdown in permit approvals? All of these are present realities right now. One of the projects we invested in has experienced this issue, but they are doing fine since the operator “expected the unexpected.”

Seasonality is a bit more predictable. Self-storage lease-ups are seasonal in most markets, and you need to build this into your pro-forma. The Florida deal I mentioned above soared in the spring and summer but slowed down quite a bit in the off-season. As I said in a recent article on self-storage value-adds, ancillary income sources can help but not completely buffer this reality.

From Todd Allen:

“No sponsor has a crystal ball that can predict all the future operational or market issues that may arise in their underwriting. However, proficient sponsors/operators do their best to anticipate problems and have contingency plans to offset economic hurdles. As an investor, don’t be quick to “jump ship.” Stay patient and trust the contingency your sponsor/operator’s contingency plan. Self-storage has proven to be very resilient through economic downturns, and with a good sponsor/operator, projected returns will typically be realized.”

Risk #3: Lies you tell yourself about the business model 

“If you build it, they will come.”

Do you believe this? Some investors do. And honestly, it used to work this way in self-storage. Those easy days are over (for the most part).

I sold my company to a public firm in 1997 and had the privilege of exiting Detroit for Virginia’s Blue Ridge Mountains. Amazingly, my home construction project was delayed about five months (yes, I’m being sarcastic). I had to keep my family’s stuff in self-storage for about eight months.

As a high-energy entrepreneur and a budding real estate investor, I thought: “Wow, this is an easy business! I never see anyone here, and all these doors mean passive income every month. They don’t look that hard to build. It must be a cash cow. Maybe I should build a facility.”

Thankfully, I got distracted flipping houses, starting a non-profit organization, and raising four awesome kids. But it was always in the back of my mind. And now that I heavily invest in the business over two decades later, I learned that I was right…

It’s easy to run a self-storage business. If you want to be mediocre. But it’s hard to run a great one.

Running a first-class self-storage facility is both a real estate business and a retail operation. It can include truck rentals, ancillary sales, digital and offline marketing, a face-to-face component, and so much more. This is not a passive cash cow, coupon-clipper, or whatever you hope to call it. Unless you’re satisfied with mediocrity and/or are a great delegator with a great team.

There are about 50,000 self-storage facilities in America. Independent operators run about three-quarters, and two out of three of those independents are owned by mom-and-pops. These operators usually don’t have the desire, resources, or knowledge to upgrade the facility to increase income and maximize value. This could be an opportunity for you, by the way, because many of these are the best acquisition targets.

Risk #4: Lies the seller tells you

I know an experienced operator who acquired a newer self-storage facility. It was still in the lease-up phase, and the occupancy was roughly 60%. What a surprise he got when about 10% of the tenants left the month after acquisition. And funny, very few of them showed up to clean out their empty storage units.

My friend got scammed.

I don’t know how common this is, but the seller of this facility had a whole slew of his relatives and friends on the rent roll. Their rent payments were in the books. These 50+ units drove over 10% of the gross revenue and about 15% of the net income. Sadly, this was in a highly competitive market, making this higher deficit even harder to overcome.

From Todd Allen again…

“While they are few and far between, unfortunately, some sellers will mislead a buyer by inflating their physical/economic occupancy with “friends & family” tenants. You can avoid this acquisition pitfall by asking for 2-3 years of financial and bank statements. If there is a spike in physical or economic growth that is uncharacteristic to the site, don’t be afraid to ask the seller to explain the anomaly.”

Buyer beware. Ask hard questions. Make the seller certify their rent roll as part of the acquisition. And build in enough capital to account for possibilities like this.

Risk #5: High leverage

Leverage can do beautiful things for a real estate investment. The CRE value formula is:

Value = Net Operating Income ÷ Cap Rate

So a 10% increase in income leads directly to a 10% increase in value. Leveraged at 80%, this 10% increase in value leads to a theoretical 50% increase in equity! This is a day for investors to celebrate. And a lot of them have been enjoying this party.

But what if income drops by 10% (see a few of the scenarios above). Furthermore, what if the market softens and the cap rate expands by 1% (say from 5% to 6%). What is the impact on the asset value? Let’s use a theoretical net operating income of $100,000 and a cap rate of 5% to find out.

Starting value: $100,000 ÷ 5% (.05) = $2 million. This is the price you paid. As an investor with 80% leverage, you only invested $400,000 in cash (plus closing costs) to get in.

New value: Assuming an income drop of 10%, the income drops to $90,000. And assuming the cap rate expands from 5% to 6%, here is the math: $90,000 ÷ 6% (.06) = $1,500,000. Your asset value just dropped by 25%.

Equity value: But what happened to your equity? It dropped by 125%, to negative $100,000. And your debt loan-to-value ratio is above 100%, the worst place you’d ever want to be. So, you may lose this investment to the bank if you can’t turn it around.

Risk #6: Invest with a bad operator

I was on the BiggerPockets podcast recently talking with David Greene about the rising tide in commercial real estate. We talked about Buffett’s famous quote about the tide eventually going out, showing us who is actually skinny dipping.

David pointed out that the tide in this scenario is like the cap rate in the value formula. It is primarily out of the investor/operator’s control. But the net operating income is like the swimmer. It is largely in the investor/operator’s control.

For the past dozen years, since the Great Financial Crisis, it’s felt like surfing. The tide and the swimmer were working together. It’s been great, and investors have been cashing in big-time.

But my goal is to invest with syndicators who understand the tide will eventually go out. These operators are such strong swimmers that they can outswim almost any tide. They have the tools and training in the form of…

  • a seasoned acquisition team (with an abundance of deals)
  • a stellar track record (they have succeeded repeatedly)
  • conservative debt (LTV, rate, and term)
  • systems (like property management, marketing, and finance)

Todd Allen:

“With any investment, you are primarily betting on the sponsor/operator for a profitable outcome. Ensure that the sponsor and the equity partner’s goals are economically aligned. Remember, without a dedicated, transparent, competent operator, even superior self-storage assets will perform poorly.”

If you’re going to operate these facilities, I recommend you dial this in. On the other hand, if you are going to invest passively, these are a few ideas of what to look for in syndicators and deals.

If you are pursuing the latter path, I recommend Brian Burke’s excellent BP book The Hands-Off Investor to give you the knowledge you need to vet a syndicator and their deals.

And if you’re investing in self-storage as a passive or active operator, I heard BiggerPockets has a new book out. ?

Happy Investing!



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