Capital Markets Report

Private Equity Positioned To Soar Into Storage Sector

Political changes in Washington, D.C., combined with the Federal Reserve Bank’s expectation to raise interest rates in the months ahead, could subject the capital markets to subtle changes or even strong turbulence in 2017.

Outside forces will affect how capital makes its way into self-storage, and, inside the industry, perhaps nothing will buffet the sector as strongly as the real estate investment trusts.

The five self-storage REITs had an adventurous ride throughout 2016. The REITs were aggressively pursuing acquisitions during the first half of the year and, some experts say, overbidding for prime properties. Then, during the latter part of 2016, it appeared that the publicly traded companies had backed off on buying.

Some industry professionals predict the REITs will take an even more measured approach to acquisitions and other financial undertakings this year. Prior to last year, the REITs were the darlings of Wall Street, given their decades of steady performance and reliable returns. But self-storage became an apparent victim of its own success, raising expectations on Wall Street. Investors can be a fickle bunch; when performance is lower than their expectations, they are quick to punish stocks.

That appears to be what happened to self-storage REIT stocks in 2016. As a result of the stock market and other factors, some of the REITs’ plans have been grounded.

That could open the door for private equity funds, which have largely waited on the sidelines with millions of dollars to invest in self-storage but haven’t had the right opportunities to deploy their capital. This could mean a new supply of capital for the sector, however, without aggressive REIT participation, some facility owners may be disappointed that their properties don’t measure up to the same values they saw in the market last year.

For owners looking to refinance, expand, remodel, or acquire new properties, there are still numerous sources of capital available. “It’s a great market for self-storage owners,” says Devin Huber, a principal with The BSC Group in Chicago. “Self-storage is being widely accepted by lenders given its historical performance through the recession. Lenders can’t get enough storage exposure, especially on stabilized properties.”

Capital Sources

Depending on need and a variety of other factors, self-storage operators are able to acquire capital from local banks, credit unions, national lenders, insurance companies, commercial mortgage-backed securities (CMBS), and Small Business Administration (SBA) loans, as well as private lenders.

According to the 2017 Self-Storage Almanac, local banks have been the primary source of capital for most self-storage owners. “Borrowers will often find that local and regional banks can produce extremely compelling quotes. A local or regional bank is the most likely lending partner for a developer with a viable project in a high-demand trade area,” the Almanac reports.

The typical insurance company prefers to lend on high-quality stabilized assets in core markets, with a focus on experienced, well-capitalized borrowers. Although life insurance company lenders historically prefer a $5 million loan minimum, increased competition has motivated some companies to lower this minimum.

SBA loans are made to small business owners by a bank and partially guaranteed by the SBA. This guarantee minimizes the risks of lending to borrowers who might not qualify for traditional financing. SBA loans usually benefit owners in secondary or tertiary markets who may be limited by traditional financing options.

CMBS lenders have historically been a compelling source of funding for self-storage owners. CMBS loans are non-recourse debt products that allows borrowers to achieve leverage up to 75 percent or higher. CMBS lenders prefer large primary-market deals, but they also compete for loans as low as $1 million in secondary or even tertiary markets.

CMBS lending has proved to be volatile during certain economic periods, including last year. “Capital market volatility, higher investor yield expectations, and uncertainty about new regulatory implementation stunted CMBS volume in the first half of 2016,” the Almanac reports. Data from Commercial Mortgage Alert shows that U.S. issuance totaled approximately $51.8 billion as of October, down from $81.6 billion through the same period in 2015.

Movement in spreads was one of the main reasons why CMBS had such a rocky start to the year. Another complication involves regulations that went into effect in December as part of the Dodd-Frank Act, which requires lenders to hold on to a larger portion of conduit deals. This legislation has caused some flux in CMBS activity and may continue in the future.

New Players In The Game

In additional to these traditional sources of financing, newer players are starting to enter the self-storage arena. “We are seeing real estate private equity groups, pension funds, and more recently sovereign wealth funds and international money trying to get into the space,” Huber says.

A sovereign wealth fund consists of pools of money derived from a country’s budget and trade surpluses, and from revenue generated from exports. These funds are set aside for investment purposes to benefit the country’s economy and citizens.

“There is more private equity money coming in than I’ve seen in the past,” says Kate Spencer, managing director of Cushman & Wakefield’s Self Storage Practice. “Returns over the last few years have attracted interest from a variety of people who are looking to get in.”

In recent years, private equity groups ran up against a REIT in their bids to acquire prime self-storage properties. An example of this was last year’s acquisition of LifeStorage by Sovran Self Storage, a Buffalo-based REIT that changed its name to Life Storage following the purchase of 84 stores for $1.3 billion. “That’s a good example of a large transaction where there was a lot of interest from new equity to acquire that portfolio, however, it went to Sovran,” Huber says.

Another hurdle players outside of the self-storage realm have to negotiate is the limited amount of choice portfolios available for sale. “When you have a pension fund, a real estate equity fund, or a sovereign wealth fund trying to deploy hundreds of millions of dollars, it’s not impossible in self-storage but it’s extremely difficult to do because there’s just not that many transactions of that size,” Huber says. “When there are, they have to compete ferociously with public REITs and well capitalized existing operators.”

Huber adds that many institutional equity sources want to write checks for $100 million or more, but transactions of that size are relatively rare in storage. “When you’re talking $200 million-plus portfolios, you can probably count on one or two hands the number of $200 million-plus portfolios that traded each of the last several years.”

$100 Million-Plus Deals

In addition to the LifeStorage acquisition, 2016 saw large operators and private equity firms acquire major portfolios:

• National Storage Affiliates (NSA), the newest self-storage REIT based in Glenwood Village, Colo., made a splash in September when NSA partnered with a pension fund to acquire Winter Haven, Fla.-based iStorage and its 66-facility portfolio for $630 million.

• Harrison Street Real Estate Capital sold 13 properties for $186 million to Sovran Self Storage (now Life Storage). The portfolio encompassed assets in New England, Texas, and California, allowing the REIT an entry into the Los Angeles market.

• At year end, Casey Storage Solutions of Auburn, Mass., sold a portfolio of 13 facilities in four states to an institutional joint venture for nearly $100 million.

• Toronto-based Brookfield Asset Management and its institutional partners acquired Orlando-based Simply Self Storage with over 192 operating facilities for $830 million.

• Crow Holdings Capital-Real Estate (CHC), a Dallas-based asset manager of private equity real estate funds, announced last year it plans to expand its investment activities in the self-storage sector. By the second quarter of 2016, CHC had acquired or provided joint venture development equity for 14 self-storage facilities across the U.S.

• Another institutional investor, Prime Group Holdings, has been among the largest buyers of self-storage properties. Prime Group had planned to invest more than $450 million in self-storage properties for 2016.

While 2016 was an active $100 million-plus portfolio sale year, the general consensus in the brokerage community is that fewer large portfolios will change hands in 2017.

“It will be an active transaction year, just not as many large portfolios,” says Greg Wells, senior director of Cushman & Wakefield, who brokered the sale of the Magellan Group in Southern California to Sovran for $105 million last year.

Private Equity Takes Flight

For the five self-storage REITs, 2016 was the best of times and the worst of times. Flush with cash, the first half of the year was a heady time for deal-making. The REITs were actively scooping up mega deals while private equity players were left out of the mix.

But near mid-year, comfortable tailwinds turned into turbulent headwinds. One of the issues the REITs contended with during the year was a slowing of net operating income, which fell to single digit growth compared to double digit growth of previous years. At another time, this level of return would be acceptable, but self-storage prior to 2016 stood head and shoulders above other REIT sectors.

In addition, the REITs had to contend with new facilities entering the market. The competition affected lease-up timing and rental rate growth. Also, increasing interest rates have impacted operations.

As a result, the storage REITs suffered a deterioration in their stock prices throughout the year. In fact, a NAREIT index of REIT sectors indicates that self-storage stocks had the worst investment performance in 2016 with a minus 8.14 percent return compared to a positive return of 40.65 percent in 2015. The only other REIT sector showing a negative return for the year was the regional malls category.

“Self-storage had been in such a year-over-year exponential growth rate that you saw some profit-taking,” Wells says. “Some of that revenue growth was driving that stock appreciation, so as that has started to slow, investors said it’s a good time to sell. Things were on such a hot run for so many years there needed to be some correction on stock prices.”

Also, the sector’s energetic development rate may be making Wall Street uneasy. “The REITs’ stock prices were priced to perfection and so any slowdown in rent growth or same store sales is what’s caused a pullback in the stock price,” Huber says. “That coupled with the uncertainty of what new demand is going to do to rental rates and occupancy has Wall Street taking a more cautious view.”

The various headwinds and lower stock prices may be causing the REITs to be less aggressive in how they price acquisitions. “Toward the end of the year their underwriting started to be more conservative and they were pickier with what they were buying,” Wells observes. “That coincides with their quarterly earnings; they’ve had some quarters that their revenue growth has slowed from previous quarters, so they started building slower revenue growth into their model, which makes them potentially a little more conservative in their underwriting.”

This could allow more private equity to enter the market. “Before the summer of 2016, a lot of private equity wanted to get into the storage market, but they couldn’t compete with the REITs,” says Steve Mellon, managing director at Jones Lang LaSalle in Houston. “Since the summer, the REITs have become more selective in their pricing. This is great news for the private equity world because they can jump in and fill the void of the REITs’ activity.”

The byproduct of this phenomenon is that some properties are fetching lower bids than owners were expecting. “The private equity groups are now able to buy at a price that six months ago the REITs would have just outbid them,” Mellon notes. “Private equity groups couldn’t get the underwriting to pencil at the price REITs were offering. If the REITs aren’t going after that asset, it’s not going to get the same amount of money for the owner as it could six months ago.”

When private equity firms enter the self-storage space, they sometimes partner with operators who own multiple properties and want to expand their operations. The facility owners usually don’t have the capital to purchase the properties, so the private equity firms provide upwards of millions of dollars for investment.

The potential pitfall in this arrangement is for the property that is targeted for acquisition. “When an owner receives an offer, it is very important for the seller to understand the equity source behind the operator that made the letter of intent,” Mellon cautions. “The trend I expect in the next 12 months is operators placing numerous properties under contract and closing on the better deals and dropping the contract on others that their equity partner declines. You’re going to see a lot of deals have false starts.”

Changes In The Wind

While owners of stabilized properties should have few issues finding funds for their pursuits this year, there are some caution signs ahead. With the accelerated rate of new development in recent years, construction financing may become more scarce. “While banks are offering construction loans, they are doing so with caution, preferring guarantors with strong balance sheets and significant development experience,” according to the Almanac.

“We have seen a tightening in the capital markets with regard to self-storage development loans,” Huber says. “We think the tightening is due to the amount of product coming out of the ground the last couple of years. Many of the lenders are getting filled up on their construction or development budget and are taking a wait and see on how deals that we have in the pipeline perform. Because we’re starting to enter the later part of the development cycle, we are seeing a measured pullback from lenders in the development space.”

This apparent pullback appears to be concentrated only in certain markets for now, as some lenders become more selective about advancing funds to specific markets or sponsors.

“That criteria might mean there is less construction financing, but I don’t think it’s an industry-wide pullback because there is too much supply coming in. It’s very trade-area specific,” says Wells.

“I haven’t heard of any of the lenders I work with say they’re no longer doing any self-storage construction lending,” Spencer adds. “By the time it gets to us when we’re bidding appraisals, that’s all been vetted, so I’m still doing plenty of construction loans in Texas and certain markets can support that. It’s a function of doing due diligence before accepting the deal.”

Another possible headwind is the prospect of more interest rate hikes from the Fed, but self-storage has a reputation for riding out storms better than other real estate sectors. “As interest rates rise, cap rates have to follow,” Huber says. “I think self-storage will be somewhat sheltered because of the amount of new capital still trying to get in. There’s a lot more demand for storage than there is supply from an investment standpoint, and that will keep cap rates compressed. As interest rates move up, self-storage cap rates won’t move up as rapidly as other asset types.”

How will rising interest rates potentially affect the ability to finance new projects? “If a buyer is debt sensitive and they used to be able to borrow money at four percent and now it’s 4.5 or five, their cash flow is directly affected and they will adjust their underwriting accordingly,” Wells says. “I don’t think a rise in interest rates would slow development financing; it’s just going to get built into the numbers.”

Spencer echoes that sentiment. “There is still so much demand for storage product that so long as interest rate increases are on the lower end, it will likely not have much effect on cap rates because there is so much demand.”

David Lucas is a freelance writer based in Phoenix, Arizona, and a frequent contributor to all of MiniCo’s Publications.