During this crisis, what is the state of the self storage market in this environment? What should operators prepare for? Where should you look for opportunities? We talked with RK Kliebenstein, President of Coast to Coast Storage, he has over 30 yrs of experience in the industry, his firm is a highly respected self storage consultancy company that provides help in all stages from acquisition, to disposition, and everything in between.
What is the state of the self storage industry today?
I come at it from thinking about past experiences, trailing all the way back to the Tax Reform Act of 1986, and what happened with the savings and loan debacle. And then fast forward to probably the second most recent event, September 11, which I think has the greatest parallel to the current event. The September 11 event happened obviously on the 11th of September, which means that from a self storage perspective, our rents are paid in advance and those rents for September are typically paid in the first six days of the month. Not all storage operators including Extra Space, one of the publicly traded companies, collect their rents on the first of the month. Extra Space uses an anniversary date, which means that whatever day that you rent your space, that becomes your due date. But most of the operators, particularly the independent owner operators, will collect their rents on the first of the month. Having said that, this event meant that most of the rents had been paid in March, when the stay at home orders a stop work orders occurred. The March rents had already been paid.
I think that the April rents, which are now due starting today, and will be paid in their bulk for the first six days of April, will likely be a pretty big tell as to what’s going to happen. From a collection standpoint, I think that because a lot of folks worked, or at least around the payroll through the first three weeks of March may mean that they have not really felt the full impact of this. And in terms of how they choose to spend what money they have, whether the priority is for cell phone, rent, storage, food, whatever that prioritization may be, I’m not sure that we’re going to feel the effect until after the May rents are due. So I think that we’re going to see a fairly good tell by April 15th, and are really much better tell by May 15th.
I was on a call with a data provider yesterday and it was interesting to hear that self storage inquiries, web traffic and phone traffic is actually up slightly, and they had not seen a fall off of inquiries for new rentals. Now what they could not give us was data points that said, how many of those web inquiries and telephone inquiries to call centers had actually converted to rentals. So we don’t really have an idea yet of how this is going to play out. We do think that in the markets that are most heavily influenced by students, where dormitories had closed and on campus housing had been shut down, that those students who were forced to move out may have been a part of that bulk inquiry as they found places to put their things during the times that they were going to be displaced out of the dormitories and student housing. So that could have composed part of the inquiries that were out there and may have some positive effect on rentals as students seek places to put their belongings as they are displaced. From a commercial standpoint, I don’t honestly think that we’re going to see that until May 15, and possibly even June 15, in terms of folks actually vacating out of their leases, or if they had a loan that they were already perhaps past due on and they couldn’t get a forbearance, or work out something with their lender. There may be some of those folks who seek shelter and sell storage for their business goods to store. There have been, early on, so many prognosticators who felt like this was going to be a very deep V and that the bottom of the V would be very short in time, and then a very quick and rapid recovery to even perhaps above where the previous levels were, particularly equities. And after having spoken to a number of folks in the equities market, wealth managers, advisors, etc, I think their general sentiment is this going to be more U shaped, not as V shaped as maybe some of the others have predicted or the early predictions were, and that we may not see a full recovery of this for as much as 24 to 36 months. How that plays into commercial real estate and to self storage transitions favorably in some cases, because self storage has been recession resilient or resistant in almost all downturns, even during the Great Recession.
In 2008/2009 we saw that self storage was one of the last sectors to be hit and one of the early sectors to recover. That should have the same kind of scenario amongst stabilized properties in this environment. The biggest challenge is going to occur because we have had so much new product developed since the recovery from the recession. And there is still so much new self storage development being completed at this time, that we have never had a recession or an event at this point in the cycle where the inventory, particularly of unrented space in new projects is so high. The other interesting development here is that our products have become a bit more gentrified. In 1986, when we had a recession after the Tax Reform Act and financing collapsed because of the savings and loans debacle, we were a fairly young industry at that point, we didn’t have nearly as many stores as we have today in self storage. And we certainly didn’t have a lot of new development at that time. And we didn’t have a lot of experience factor. By the time we got to September 11, the industry had matured to a much greater extent. But we still didn’t have quite as much inventory as we have today. And it wasn’t quite as gentrified or as mature as it is today. So we’re also going to see now the effect on older stores that maybe could have or should have put more capital into releasing their reserves that they had for replacements, and doing things like painting roofs, asphalt or concrete, or big areas of exposure to self storage. And probably the last major component that needs to be replaced are the doors because those doors that were put on in the first two to three decades of our industry, remembering that our industry didn’t really start until late 60s, early 70s. And as a result of that we hadn’t built as though this was going to be a long term play.
It’s interesting that back in the day in the 60s, 70s, and even early 80s, we thought of self storage as a land banking play. And that the locations we chose were in the back of industrial parks. They were the end of cul de sacs. They were down the road. They weren’t at Main and Main, or Main and Second Street where locations are really focused today. And so those older products are not in the public eye nearly as much as the new products that have been built, where we’ve really encroached into the retail atmosphere as we have greatly increased the level of investment in a store. Back in the day you would build 25 or 30,000 net rentable square feet, and self storage could be built in its early days for $20 a foot. Today goes construction costs run closer to $85 to $90 a foot in almost any market. We have a much bigger investment today, a much higher profile location, which means that our exposure in new projects is much greater than it was even in the September 11 category. So we do have a bit of a different environment. And that may mean that we’re not able to use quite the same predictors that we did in the past, but I do think that we have a much better footprint to look back to in the September 11 experience than we have had before.
How should the operators prepare for this potential economic hit? What does it mean really, for all the different components of our business?
For tenants, it means that they may have to stop making payments because they just don’t have that component. For new incoming tenants, they are able to execute the new lease agreement process 100% online, with no contact. And that is not ubiquitous in our industry, that is still reserved to a more select group of owner operators. Although I have seen press releases over the last week, were those that were trailing and lagging in their ability to rent totally online, particularly in large owner operator groups, they have accelerated the ability to do that. They’ve executed the technology they needed. And a lot of those that were lagging behind in that aspect are now coming on board and are able to fully rent without contact. So those who have not started that process or have even maybe not thought about it are going to probably lag behind in the ability to rent new units and spaces if they have to close their offices or limit contact. I’ve made recommendations to a couple of my clients that they offer to waive rent payments in May and June if we’re not fully back to work, for those tenants who have been tenants over a year or over two years as a reward, if you will, for their loyalty and their perhaps continued loyalty. I’m not sure how that’s going to play out at the end of the day, but certainly it’s an opportunity for them to offer something and create some goodwill as a result of it.
The other interesting part of this is how it’s handled from a lien perspective for the Self Storage operator to their tenants. One of the most terrific parts of self storage is that there is no other real estate class that is as favorable in lien laws to the landlord as self storage. If you as a landlord follow the statute for removing someone’s goods from a space and selling them if they don’t pay their rent, there is no better process that is in higher favor to the landlord than self storage. Now the question is begged “Do I go ahead and continue to work through the lien process if my rents are unpaid?”. There are notifications that occur in this process, typically between five and six days, you charge the first late charge and walk them out of the gate, so they don’t have access to their space, which you’re actually entitled to do day one after their rent is unpaid. And then typically on the 10th of the month, you would send them a notice that says that the lien process is going to begin and that an overlock has been placed on the space, which is a lock that the landlord puts on the tenant space so they simply can’t access it without coming into the office to get that lock removed, then there are some notifications that occur. Most sophisticated operators won’t take a partial payment beyond that 10th day whether or not we execute the lien process and send those notices out, which may have some public relations challenges to them for a large operator that could be perceived as predatory. But most of the Self Storage attorneys that I have spoken to have recommended to their clients that even if they’re not going to go through all of the steps of the lien process, that they at least will protect themselves by having sent the notices that are necessary, thinking that if there is a recovery that occurs quickly, and work is restored, that those folks would have an opportunity to come in and make those payments before their goods would be sold at auction. And almost no self storage operator in the country really wants a space to go to auction, despite the luster and the excitement that you see on television for Storage Wars and other shows. That’s not reality. We are very lucky as owner operators to collect pennies on the dollar for storage rents that are past due even though those may only be 60 or 90 days worth of rents at the time that we actually go to auction. We’re very lucky to recover very much, if any of those funds. And sometimes we’re lucky to just recover the rent and never get any of the late charges or fees that we were able to legally charge the tenant for. So from a tenant perspective and a landlord perspective, I think there are several remedies that have to be looked at and even some public relations issues.
For storage managers, your health comes first. I know that that’s going to be an unpopular position with some of the owner operators as employers, that their staff would perhaps not come to work, but I think that we can work from home in many cases, we don’t have to have a lot of contact with the public. But more than anything else, I honestly believe that a self storage manager’s first responsibility Is to themselves, and their family. Going to work in an unnecessary capacity is not a recommendation that I would give them. If it’s safe for them to go to work because they don’t have public contact, and they’re not in high contact with places and objects that have been touched by the public, that’s a consideration, certainly, but I know a lot of offices have just said that they’re not going to have contact with tenants directly. They’re open via chat, email, telephone.
For storage owners, it’s a different consideration as we now go into where are you at in the debt cycle. Those stores that are in highly competitive markets, where they themselves or their competitors are in lease up and there are a lot of vacant spaces, and those in the third category, the very high levered owners are going to be the hardest hit by the event and will have to make the toughest decisions. I don’t know that we’re going to see the real effect of this for perhaps 60 or 90 days as loan clauses with MAC clauses in them (Materially Adverse Condition clauses) begin to be in effect from the lenders and then also the consideration of force majeure clauses, which don’t occur in self storage month to month rental agreements, but certainly would occur in finance arrangements and contracts. It will be interesting to see how that all begins to play out and how the Self Storage sector may fare against other asset class type of lending. Keeping in mind, Self Storage has notoriously had the lowest foreclosure rates, regardless of economic conditions of any other asset class. The only one that ever has come really, really close to it are NNN leases and with triple A credit companies, and also, interestingly enough mobile home parks.
One of the big measures and metrics we look at for operations and one of our KPIs is how many move outs do you have and how many move ins do you have in a month’s period of time. If you have a 50,000 square foot retail center, and you have 10 retail bays, and each of those bays are 5,000 square feet, composing that 50,000 net rentable, and you have five year leases. You have very little exposure on an annual basis unless a lease expires but you really are dealing with 10 tenants at the end of the day. In a 50,000 square foot Self Storage property, we would typically be dealing with 500 to 550 tenants, all of those tenants being on month to month agreements. In a store that is typically one to four years old, you will turn your inventory, that is to say, you will rent basically 100% of your spaces every year. The longer the store is in place, and the more it matures, and the longer tenants stay, that then begins to reduce the tenant turns. So in a store that may be 5, 10, or 15 years old, instead of turning their inventory, or renting all 500 to 550 spaces every year, that number would go down to the 60% or 70% range where you’re not turning all of them over. But just think of the amount of traffic that you have to generate in a five year period. You’re going to have to rent 2,500 units as opposed to 10 units in a long term lease situation. It’s a very different dynamic in self storage from that perspective. The beauty of that has always been that we don’t have fixed leases. So we’re able to raise rents or to lower than as the case may be when there are vacancies, but we’re able to raise those rents with just 30 days notice. And we’re also able to boot someone out for any reason that we so choose with a rental periods notice, which is typically 30 days. Just keep in mind that we’re on a 30 day rental agreement, as opposed to long term.
What I’m seeing in terms of new loans right now is interesting. The CMBS market, securitized loans, for self storage at least, has pretty much collapsed completely. The bond market being unstable, and that being where these loans are sold, until that bond market is firmed up and we know where the pricing is going to be, I would say the CMBS market is likely to be on hold. I’ve even seen them because of the Material Adverse Conditions or MAC clauses commitments that were set to fund over the last 10 to 15 days. We’ve seen a number of different reactions to the current environment but I think the CMBS market is basically collapsed.
I think the only viable market right now is the life insurance company market, they seem to still be quoting, and closing loans that were in process. I think that their underwriting has changed a bit. But that market is still a little bit active.
The banking market for self storage lending is on hold, when the first reaction to the turn in the economy was to lower the Fed rate, that actually put a lot of lenders in a position to increase the interest rate floors. That was what I saw as the first tell, and then just absolutely not funding or not taking on new applications was the the second tell.
The last group that I work most specifically with are developers. Developing new self storage projects is very challenging right now. The advice I have given my clients is first and foremost, be communicative with your sellers. If you’re going to need an extension, if you have a loan in process that you’re working side by side with your entitlement process, but you fully expect to use a construction loan to close on the land. Just be highly communicative with your seller, let them know where you’re at in the process, maybe even in full transparency, giving them access to your relationship manager at your lender, so that everybody knows who’s on first, what’s on second. And I would say be communicative across the board. Whether you’re a manager, you’re a tenant, you’re a self storage owner, operator, landlord, a lender or a developer. My number one advice to everyone is just keep the lines of communication as wide open as possible. Hiding from it right now and not coming to the tab le is probably the worst thing that you can do. It is not the most cherished of tasks, but I believe it should be very high on your priority list to open those dialogues. If you are moving ahead with purchase and sale agreements for developments, my advice is that you make sure that the timing on that to get to either close of due diligence and or to settlement, is typically based on the entitlement process. We usually say, look, we’ll close 30 days after we get our use approval and site plan approval. That’s the typical developer’s due diligence period.
And today, because we don’t know what’s going to happen with public hearings, we don’t know what’s going to happen with building inspections, instead of tying into calendar days, which we typically do which is to predict how long it’ll take us to get through the entitlement process. And then we’ll say, okay, if it’s eight months, and we’re going to ask for an eight month contract. Instead of doing that, I would say, if you need three public hearings to get through, tie it to 15 days after the three public hearings. It’s going to be more fluid, certainly less comfortable perhaps for sellers because they’re going to be open ended on a close with due diligence money going hard and settlement date. But if they want to stay in the game, that’s really my advice right now, to tie it to your loan commitment if you’re going to be needing that in order to construct, or the entitlement process.
Do you have any approaches on how to look for deals, and how to negotiate during these times?
I’m actively looking at transactions right now on behalf of a couple of my clients. Certainly, we’re much more cautious and our underwriting has changed significantly. I don’t think it’s time yet to be put in a position to be opportunistic based on transactions that weren’t opportunistic before, March 1st. It’s still status quo along those lines, although it’d be interesting to see what has happened to those call for offer dates that occurred between March 10th and today, and what the reaction has been from potential buyers. We had an offer in place on a property in Florida in an almost a tertiary market, certainly a secondary market, an existing store fully stabilized that we were going to expand. We were in the best and final group and then as brokers often do in the self storage space, best and final never means best and final, it means you’re going to get one more chance to have a higher price extracted from you as a buyer, which is exactly what happened. The brokers came back and said, okay, it’s not really final investment. Now we have a new final investor, we want you to tell us how much you’re going to step up. And my group said, you know what, we’ll stay at where we were, we were comfortable with our original offer, but we’re not going to get more aggressive. I think what we’re going to see happening is that there are going to be much more conservative offers put out because we don’t know how the lenders are going to react. We don’t know how collections are going to react, and all of those things as we go forward over the next six months. So I think that we’re going to see an increase in cap rate, which certainly doesn’t hurt my feelings as a buyer of storage projects. We’ve been working in an extremely challenging environment where Self Storage cap rates have been in between 5-5.5% for A market, A locations, fully stabilized stores that were built after 2005, all the way up to maybe 6.5 cap for tertiary markets, older stores, maybe some that needed repositioning and/or capital improvements. So I’m thinking those cap rates are going to move upward and we’ll see a little bit of relief on pricing in self storage.
And again, timing when you’re going to close and when you’re going to close your due diligence period is now really affected until certainly travel bans are limited because if you’re in a tertiary market, it’s hard to get a property condition assessment report done if you can’t get someone mobilized out there to do it, let alone your own onsite due diligence where you’re going out to look at properties and to do the performance audits. So all of those timeframes become a bit of a moving target. And it’s not as easy and clean to say, which was typical in self storage, a 45 day due diligence period with 15 day close.
In self storage is a little bit different because the oversupply has caused rents to drop in almost every major market, I’d love to have a conversation sometime about the paradigm shift that’s occurring in self storage relative to the effect from over building and from new building. But certainly one of those is a migration from primary markets to secondary markets. And then I saw a couple of groups talking about maybe even looking into tertiary markets to seek a safe haven from overdevelopment. And that over development has materialized in a reduction in rental rates. Again, because we have those 30 day contracts and we can increase those rates, we can put somebody in at a teaser rate, and then very quickly move them up to higher rent markets. So all of that makes very, very easy rent manipulation. But what happens in the revenue management tools that are deployed in self storage which are no different from airline seats, hotel rooms, car rentals, it’s totally supply and demand based and when a new self storage property opens up 500 yards down the road with 1,000 new spaces, and they’re the new kid on the block with the shiniest windows and they look the best. And all of a sudden, in order to get full, what we call butts in the seats to rent space, they’ll reduce the rate from a standard rate of let’s call it, just to use easy math from $200, they’ll reduce it down to $100 to induce folks to take rentals. Well, that affects everybody all the way down the chain because the natural reaction for the guy who’s fully stabilized at least on his new rentals coming in is to bring their price down so that they can help to share in the new tenant movements that are out there . We already had a pretty interesting situation in most major metropolitan markets that had felt development, those rents were already suppressed. So I don’t know that we’re going to see yet another cut and tear significantly in rent reduction because it had already happened in many cases. So you’re right though, it’s going to be very interesting to see how all sectors of real estate are affected by the current event.