Buy Or Build?

Investment Insight For The Best Deals

Back in the spring of this year, Sovran Self Storage, Inc., of Williamsville, N.Y., announced it would acquire LifeStorage, LP, a privately-owned self-storage operator for about $1.3 billion. In the deal, Sovran will end up with 84 LifeStorage facilities and a purchase contract to acquire three more facilities in the years ahead. While this deal might be further proof that the acquisition market is still red-hot, a number of brokers and financial sources are suggesting that the time is right for new development.

“It’s hard to broadly state whether buying or building is better,” says Elliot Pessis, a senior vice president with Harrison Street Real Estate Capital LLC in Chicago. “You have to look at the rate of return on each individual investment opportunity and compare it to your own cost of capital.”

Harrison Street was founded by Chris Galvin, whose grandfather was equally entrepreneurial, having started up a little company called Motorola. Harrison Street is a real estate, private-equity fund that primarily invests via joint venture partnerships. Over the past decade it has worked with about 15 different self-storage operators. A Harrison Street joint venture generally looks something like this: It will put up 90 percent of the equity with its joint venture partner contributing the final 10 percent; then it will leverage up 60 percent to 70 percent. So, if an investment costs $100, the venture will seek to procure $70 of debt proceeds and Harrison Street will contribute 90 percent of the remaining $30 with the partners contributing the balance.

Harrison Street is doing more acquisitions than development right now, although Pessis adds, “Clearly, the yields aren’t where they were a few years ago. You used to be able to generate a 300 bps [basis points] spread between your stabilized yield-on-cost and your exit cap rate. It’s tougher to get that these days.”

The cap rate on the Sovran acquisition was rumored to be in the four-plus percent range. When asked if Harrison Street would acquire at a four percent cap rate, Pessis says, “The property would have to meet our investment criteria. It would have to be a stellar property for us at that cap rate and likely be located in a major MSA. Even so, I would still have to underwrite it, look at new supply coming online, evaluate rental rates, and ensure that I meet my investment criteria.”

Whether to buy or sell, depends on the investor’s risk tolerance, says Aaron Swerdlin, an executive managing director with Newmark Grubb Knight Frank in Houston. Swerdlin thinks the acquisition market has been fairly picked over throughout the last three years, but that doesn’t mean he is less busy than a year ago. In fact, he says he is even busier this year underwriting deals. The difference between the two years being the bigger stuff might have already been taken.

“The profile of properties we are looking at is different,” Swerdlin says. “The average size of what has traded over the past two years is lower.”

Here’s what is happening in the deal market: Cap rates can’t go much lower in the Class-A markets because there is no yield, so investors are moving to smaller, secondary and suburban markets even though yields there are beginning to look a lot more like core yields.

“The focus today is more on location that anything, so if there is a property that looks old and tired, without all the bells and whistles but faces major retail, it’s attractive,” Swerdlin says. “It’s not unusual to see a 15- to 20-year-old facility sell for a four-plus percent cap rate if the ‘dirt’ is in the right location.”

It’s Not Binary
All that being said, there is a compelling case to be made for development. “If I’m going into a suburban market and my yield is in the four percent range but I can develop to a seven percent yield, then the latter begins to look compelling,” says Swerdlin.

Oddly, it appears that a lot of commercial real estate brokers watched last year’s movie about Apple’s founder Steve Jobs. At one point, Seth Rogan, who played Apple’s co-founder Steve Wozniak, says to the Steve Jobs character, “It’s not binary. You can be decent and gifted at the same time.”

When the question came up about whether it’s better to buy or develop in today’s market a number of brokers reported that it’s not binary. “Developers call us all the time to discuss Certificate of Occupancy deals or to pick our brains on development,” says Pessis. “It’s the most that I have ever seen, but there are still buying opportunities out there. It is not a binary thing.”

And Swerdlin comments, “Buy or build? I don’t think it is a yes or no; it’s not binary. It’s contextual and depends on the risk tolerance of the capital. The capital decides whether it is a build or a buy.”

The spread between building and buying is about 150 to 200 bps, observes Steve Mellon, a managing director with the National Self Storage Team at Jones Lang LaSalle in Houston. “With a build you have to wait until the property leases. An investor can search and acquire older product or a small portfolio of B-product, which will probably earn approximately 6.5 percent return. With a 4.5 percent loan, an investor can leverage their returns immediately,” he says. “If the investor is patient, building will have a slightly higher return on better product, but the property will not cash flow until year two or three.”

Going Up

Real estate investment trust analysts suggest this year is going to be an outstanding year for self-storage; and the next two years will be as well, although the growth rate will slow. None of that is surprising. In the last 24 years, the National Association of Real Estate Investment Trusts reports that self-storage holds the highest shareholder return of all of the property types by a good margin. Shareholder returns has been in the high-teens; the next most successful sector being multifamily, with returns in the lower teens.

“If you look at the fundamentals of the sector, they have never been better,” says John Good, president and chief operating officer of Memphis, Tenn.-based Jernigan Capital, Inc. “When the recession hit, development stopped. After the recession ended we had a five-year period where there was no new supply in the top 50 markets. Historically, 350 to 400 facilities per year needed to be built just to keep up with population growth. A significant supply and demand mismatch resulted.”

“The fundamentals of the sector are tremendous and we expect them to continue for the foreseeable future,” says Good. “As long as self-storage fundamentals remain as strong as they are now, capital will flow into the sector. We ask ourselves, will that capital be allocated to acquisitions or to new development?”

Jernigan Capital calls itself the leading investor in self-storage development. It has approximately $200 million invested, most of it in new developments in major U.S. markets. Its business plan is to continue to do the same through the current development cycle.

Most new development is not done by self-storage companies but by independent developers who also build multifamily or small office. Since the recession, multifamily has been the hottest commercial real estate sector in regard to new development. Now, some of those same developers are shifting away from multifamily to self-storage because they see the demand/supply equation in that sector has shifted toward new construction.

Jernigan Capital is considered a specialized investor focused entirely on self-storage, partnering with developers in the top 50 U.S. markets and looking to do a whole lot more than the $200 million already invested.

Obviously, this is a company a lot more interested in financing development. “The reason for that is the mismatch between supply and demand and need for new supply,” says Good. “We feel like new supply is where the higher investment returns are right now as opposed to acquiring properties.”

All of the REITs are aggressive buyers right now, Good adds. “Sovran just announced a very large portfolio acquisition at a cap rate in the fours. We can fund development with returns in the high single digits with less competition, as commercial banks are largely staying away from self-storage development for regulatory reasons.”

Jernigan Capital has stepped in to fill that void. “Our focus on development produces returns that match our cost of capital while at the same time addressing the supply and demand imbalance for the sector at a time when other capital sources are reluctant to provide the capital to solve the supply/demand issue,” Good says.

Wentworth Property Company LLC (WPC) in Phoenix was created about 11 years to develop and acquire office and industrial properties. About a year ago, it decided to add self-storage to its portfolio, hiring Dave King (formerly with Westport Properties) to lead that effort.

Since September, the company has acquired 10 self-storage projects. It purchased three value-add sites in Las Vegas; is doing three conversions in Maricopa County, Ariz.; bought two distressed properties in Los Angeles, which will eventually be knocked down and redeveloped; closed on a Portland warehouse to be converted to self-storage; and purchased a value-add deal in Phoenix which will be expanded.

“We have a three-pronged approach, which includes value-add acquisitions, ground-up development, and conversions,” says King. “We like conversions, or the repurposing of older structures, which in my opinion is more like development. We can bring those properties to market faster than ground-up development. WPC’s background as a commercial real estate developer has been the key to the rapid growth of the company. As an example, we bought an old furniture store in Tempe, which we will gut, build a mezzanine, and deliver two stories of air conditioned self-storage in under a year.”  

Conversions are not easy, but WPC likes turning dark, vacant buildings into Class-A self-storage properties. When asked if it was a better strategy today to develop or acquire, King’s reply was to develop.

“It is harder for us to compete and find value-add acquisitions,” King says. “For a stabilized core asset, we are not a big competitor. We need to be able to add value through better management, some Cap-Ex, and better marketing. It’s definitely a good time to be a seller of anything storage related. We’re trying to be creative with our approach in buying more distressed, value-add assets, but even those are getting harder to come by. A lot of us are out there looking for scale, and it’s a very competitive but fun time to be in this business.”

The Big In-Between

Certificate of Occupancy (C of O) deals have been growing in popularity, possibly because these transactions occupy a mid-point between development and acquisition. As noted in past articles, REITs, which for a number of operational reasons would prefer not take on development risk, form contracts with merchant builders to develop projects. After completion, and once the Certificate of Occupancy has been achieved, the REIT will buy the property.

“We have sold a fair amount of C of O deals in the last few years due to the very slight discount in price compared to stabilizing the property for two or three years, then selling,” says Mellon. “Generally, if a product is owned for two years and is 80 percent leased, the market will bear approximately a five percent cap. If you had that same facility and just opened the door, it might sell it for a 6.5 percent or seven percent cap based on proforma cash flow at 90 percent occupancy.”

“We have raised debt for construction loans, and the biggest hurdle has always been securing a loan that is non-recourse,” Mellon adds. “It is a lot easier to get debt on a cash flowing property, thus a non-recourse loan is standard versus a C of O deal that is not cash flowing. However, we have been successful lately that lenders will accept a ‘completion guarantee,’ which is a recourse loan, but the minute the sponsor receives the C of O, the loan becomes non-recourse. You are guaranteeing the loan until you complete and then the bank has a real asset it can take back.”

“If you have more patience, it is better to build,” says Mellon. “Generation one and two product is obsolete versus building a new facility with modern amenities. Building has a better exit strategy due to more options. But, you better be patient because you might not get the return until it leases up, which might take two to three years, hence the risk. Product even just one or two generations old is looking obsolete. That’s not what happens if you build it today.”

The majority of these C of O deals that are getting done at aggressive pricing levels are located in very strong, urban markets such as Boston, New York, Miami, and the land-restricted cities of the West Coast.

“Developers who have found success with C of O deals are only doing these in the markets where they are well paid, and, nevertheless, it is still cheaper than big buyers like REITs having to create a development department, get the entitlements, zoning, etc.,” says Swerdlin. “The C of O deal structure doesn’t work that great in the suburbs, but it works really well in the core urban markets.”

Buyer/Seller Disconnect

Going back many years now, as the transaction market picked up steam after the recession, there evolved much discussion about the disconnect between buyers and sellers when it came to pricing self-storage. Someone looking at the self-storage industry and the heady number of deals getting done this year, plus last year and the year before, would think that whatever disconnect may have existed certainly has evaporated. Somewhere along the line, buyers have laid out a pricing structure that sellers can accept and everyone who has an interest in acquiring has followed that model.

Despite the rampant deal making of the past couple of years, when Mini-Storage Messenger did a quick, unscientific survey of self-storage brokers and financial sources, most everyone suggested brinkmanship still abounded. “That disconnect is still going on, even more today than ever,” affirms Swerdlin.

The severity of the disconnect depends on the quality of the property, says Pessis. “The disconnect starts when a self-storage owner with a Class-B property expects Class-A pricing, or when a Class-C self-storage owner expects Class-B pricing.”

Not all storage properties are equal, Pessis adds. “Self-storage properties in the top metro areas of the country are going to command higher valuations and lower cap rates than those in a secondary or tertiary market. When people don’t understand that the disconnect occurs.”

People get confused because so many properties have sold at such aggressive pricing levels, but most of the deals getting airtime are the deals priced most aggressively, says Swerdlin. “There is probably more stuff on the market today than there has been in the last three years, but, relative to cap rate expectations, the quality is lower. People think, ‘hey, I have self-storage; I see Sovran just did a deal with a four-plus percent cap rate so my property must be worth the same. I’m going to put it to market.’ There are just not that many markets out there where a small portfolio or a one-off deal is going to sell for a four-plus percent cap rate.”

Pessis believes educated buyers and sellers understand current pricing. Swerdlin somewhat agrees with that notion. “Owners in Class-A metros are aligned to where the market is and there is not a lot of education that needs to take place; owners that are an hour from 25^th largest CBD, that’s where the education is necessary,” Swerdlin says. “They are applying Brooklyn pricing to a situation where there’s a population of just 3,000 in a five-mile radius.”

Mellon prefers the word “methodology” to disconnect. “A seller might think his or her property is worth a 6.5 percent cap rate, but you have to ask the question, ‘What are we capitalizing?’ Everyone can usually agree on income. It’s the expense structure where we run into trouble,” says Mellon.

Mellon used this example: “This guy owns a property and says it is worth $5 million, but the tax assessor has it at a $1 million valuation. The owner’s brother Billy Bob does the maintenance on it in return for getting his garage doors fixed. We agree on cap rate, but if I buy it for $5 million, my tax rate may go up to $3 million. I have to underwrite that as a buyer. Your brother Billy Bob does all this maintenance for free, but now I have to find someone to do all that work. My assumptions might be different from your assumptions. We both agree on the same cap rate, but the way I look at the expenses can be vastly different.”

Swerdlin cautions, “There is not a standard for getting to a cap rate. Did anyone adjust taxes, normalize payroll, grow revenue, or calculate off-trailing revenue? While people talk cap rates, they really just put it into a context that is most beneficial to them, and most of the time it is not accurate. People have expectations that are benchmarked on things without understanding the facts.”

Steve Bergsman is an author, journalist, and columnist. His stories have appeared in more than 100 newspapers, magazines, newsletters, and wire services around the globe; his most recent book is “The Death of Johnny Ace.”