Post-Pandemic Deals: Performing Due Diligence in Trying Times

For the self-storage industry, 2020 was an outstanding year with an unprecedented amount of new capital entering the sector. Some of this can be attributed to rising demand for storage as people facing a pandemic adjusted their living situations. Also instrumental was the underperformance of other real estate sectors, such as retail and multi-family, making the relative safety of the self-storage asset class an appealing option. With considerable transaction activity taking place, the demand for due diligence performance has grown while COVID-19 has made it more difficult to execute.

“All of 2020 had the highest self-storage portfolio activity since 2016,” says Chris Sonne, executive vice president and self-storage co-leader for Santa Monica, Calif.-based Newmark Valuation & Advisory. “We had a tremendous year. Self-storage REIT stocks were way up, rates of return and values increased, and we saw record new amounts of outside capital—all during a pandemic.”

Nonetheless, Sonne and others in the industry have found performing due diligence a challenge in pandemic times, particularly doing on-site inspections and anything involving third-party vendors or municipalities. Although the timeline for getting deals done has gone back to near-normal in some respects, industry professionals agree that the effects of the pandemic will linger on for projects in the works and even those going forward.

Travel And Safety

When the pandemic hit, the first attack on business as usual was restricted travel to properties under contract. Whether due to stay-at-home orders, safety concerns, or lack of travel options, it became difficult (if not impossible) to physically appear at a property.

“The biggest issue for us is travel,” Ken Nitzberg, chairman and CEO of Oakland, Calif.-based Devon Self-Storage, says. “Our acquisitions people either can’t or don’t want to travel, and I don’t want them to get on airplanes or be in airports. And they have to do physical due diligence; it’s not something you can do on a computer.”

Carol Mixon, president of Tucson, Ariz.-based SkilCheck Services, Inc., agrees that travel has been the biggest hurdle since the pandemic. “They have a lot of reports they want to send you, but I tell them I don’t want any information from them,” she says. “I go out and find it myself and tell them what’s there. Then, they can compare what I found with their own reports.” Sometimes, Mixon is called because the bank insists that someone from outside the company verifies what is in their reports, and she says nearly all of the due diligence work she performs must be done on site.

Because travelling is essential, Mixon did only one on-site assessment this year; typically, she would have done eight. “I don’t think there are fewer deals being done; I think they are hiring people who are local,” she says. “I’ve had a number of small investors coming to me who want me to look at a deal online and say yes or no. But there’s nothing like being on site and seeing where there is development in the area and seeing their competitors’ sites.”

Sonne notes that when you do visit a property, things are different than they were pre-COVID. “For a period of time at the beginning, we wondered if we should even inspect a property in person,” he says. “Should you go inside? Do people want you to do that, or do you even want to?” Eventually, Sonne did begin to visit sites but found it a new experience.

“I would look at the exterior of the building and walk through by myself,” he says. “I never had close contact with anyone. You used to be hosted at a property by the owner and manager. It was kind of a social event, whereas now, it’s more of a solo event. You might meet the manager and be given a code, but you go through alone.”

Municipalities And Vendors

For Todd Amsdell, president/CEO of Cleveland, Ohio-based The Amsdell Group of Companies, working with municipalities has caused the biggest delays. “The only real holdup for us has been the cities or municipalities,” he says. “They are much slower to react and to get good information from, or even to get paperwork filed.” Amsdell is still seeing these delays into 2021 as backlogged government agencies play catch-up.

Per Nitzberg, working with local governments has been a difficult hurdle and has added months to the process of doing deals. “If you’re doing a ground-up deal, you’ve got a huge amount of permitting ahead of you,” he says. “Getting ahold of any kind of governmental agencies for permits and approvals has been greatly extended and more difficult. Many government agencies are very backlogged.”

This has resulted in unprecedented delays in deals being completed. “Every jurisdiction is different, but you could add three to 12 months to the timeline, easily,” Nitzberg says. “Many times, we need to talk with city departments regarding zoning, building permits, or other issues. In many jurisdictions, those bodies aren’t meeting any longer, or they’re holding Zoom meetings infrequently.”

Michael Pogoda, vice president of acquisitions for Farmington Hills, Mich.-based Pogoda Companies, says zoning and other municipal matters have created unprecedented delays for his projects as well. At the beginning of 2020, they had six projects in the works. “We pretty much shut things down in March and delayed everything as well as we could,” he says. “In order for deals to happen, you needed amenable buyers and sellers who are more open than usual to being flexible with timing.” The company resumed work on their projects in July and closed on all six properties in September.

However, the company’s four current projects, which need rezoning, will be delayed as long as another year. “Being conservative, I’m looking at spring of 2022 until opening,” Pogoda says. Two of the projects are new construction and two are expansions.

Another setback in the due-diligence timeframe has been working with third-party vendors who are critical to the process. People’s inability or unwillingness to travel, fear of infection, mandated shutdowns, and backlogs have all contributed to the delays.

“Once you have something under contract, you need to hire certain services like an environmental engineer to do a report, building property condition reports, or zoning reports,” Nitzberg says. “If they have to travel, many of them aren’t doing it now. In terms of negotiating with contractors and subcontractors, many of them aren’t working. It’s hard to get people out in the field to do anything.”

Even after getting contractors to the site, Nitzberg has seen delays. “We were halfway through a project in Florida when one of the electricians came down with COVID,” he says. “We had to shut the whole job down and send everybody home. The whole industry is quasi-shut down and it’s very difficult to get things done because of COVID.

Aberrant Numbers

When looking at revenue and expenses for any potential deal, 2020 figures can deviate from previous years, making it harder to evaluate potential revenue and expenses. “It shows how important the P&L statements from the last three years are,” Pogoda says, “because in any sense of the word, 2020 was an anomaly. Our job is to look at how 2020 compared to 2019 and 2018.”

Although demand was down during the first couple of months of the lockdowns, it rose significantly as restrictions were lifted. For Mixon’s company, which offers mystery shopping and call center services, demand for call center representatives exploded around the end of March. A large self-storage REIT needed her to hire and train call center personnel when they went from around 3,000 calls per month to over 20,000 calls.

However, high occupancy was offset somewhat by losses in many regions. Moratoriums on evictions, rent increases, and auctions in some municipalities prompted some operators to simply allow tenants to pick up their stuff and go after months of not paying rent. Whether the increased demand that brought higher occupancy balanced out potential losses is a question specific to each facility.

“Occupancy across our portfolio has increased, but revenue has decreased slightly,” Pogoda explains, “mostly due to shutting down our properties in the second quarter and not being able to charge late fees.” He also notes that revenue was lost from ancillary services such as truck rentals. “The year in general came out to be a little higher in terms of revenue but also a little higher in terms of expenses.”

For many operators, payroll costs were lower in 2020 because shutdowns meant fewer people were working fewer hours. The industry also employs a high percentage of older workers, and some simply quit because they didn’t feel safe being in contact with the public. In addition, where stores were temporarily shut down, the incentive for employees to return to work as things opened up was dampened by higher payouts for unemployment.

Although Mixon says things began to stabilize in November, in many cases these jobs have been difficult to fill even in 2021. Some facility owners have had family members come in to work or hired temp workers at a higher rate. “They’re frustrated because they can’t get workers in,” Mixon says.

In any case, she says 2020 numbers may not be reflective of what that expenditure will be in the future. “You probably shouldn’t be looking at any time from COVID on to get accurate payroll costs,” Mixon says. “I’d want to look back a few years and assume that future payroll costs will be higher than in 2020.”

For Pogoda’s properties, 2020 payroll numbers were anomalous for the opposite reason. Higher payroll costs were the company’s biggest jump in expenses over 2019. They paid an additional $1 per hour and gave periodic bonuses to workers who were putting themselves at risk and taking on extra duties such as more cleaning. “We also overstaffed some facilities based on people’s level of comfort,” Pogoda says. “If you were looking to buy our portfolio, you’d say, ‘Why was payroll 20 percent higher than 2019?’ We also increased our marketing spend just to stay on top of the market with fewer people leaving their homes.”

For almost all operators, the pandemic brought unanticipated expenses. Extra cleaning has been an expense for many facilities, especially when someone infected with COVID-19 has been on site. In these cases, an entire facility may have been shut down and every surface disinfected. Mixon says her most recent quote from a company that cleans specifically for COVID was $185 per hour.

Pogoda says getting a professional company with COVID protocols to come in and clean has been a huge unanticipated expense. When his company had an outside vendor come in to disinfect a facility where there had been exposure, it cost around $750.

“Think about how big some of these facilities are, and they’re having to clean the entire property,” Mixon says. “We’ve had to send emails and letters out to every customer saying we are closing down for two days to disinfect the property.” In fact, she says, there are increased costs for cleaning in general. “The manager should be doing a lot more cleaning of everything,” Mixon says, adding that she doesn’t predict that this will change much in 2021.

Pogoda agrees that some of these expenses may stay. “Looking at the historical numbers is so important, but it’s not that 2020 should be seen as a throw-away year,” he says. “Maybe in our future projections we will increase our cleaning costs, but somewhere between the 2019 and 2020 numbers.

Investment Outlook

Even with the challenges to self-storage operations during the pandemic, the appealing features of the asset class attracted more interest from outside sources. “By July, for self-storage, things were back to full speed,” Sonne says. “We had a growth year on income and occupancy. In the fourth quarter, we saw huge investment entities like Blackstone and Cascade (an investment arm of Bill Gates companies) enter the sector in a big way.” He says market sentiment is that self-storage will continue to outperform in 2021, driving value, appreciation, and more new capital entering the sector.

Pogoda is optimistic as well. “Self-storage has really come up as a safe, new, and exciting asset class for a lot of new capital sources, especially during the pandemic where different asset types had some distress,” he says. “We’ve seen increased activity in the sector over the last year with cap rates even going lower because of how much new competition has made its way into the sector.”

Pogoda says competition for deals increased during the pandemic. Still, he says, the new players aren’t necessarily bullish on properties that are still in lease-up, not covering their debt service, and requiring a lot more work and a longer business plan. “They prefer properties that are at 85 percent occupancy or higher and just need a little sprucing up before raising rents,” he says. “However, we’ve seen people still going forward with construction.”

Nitzberg says it can be difficult today to buy existing properties because there’s a tremendous amount of money trying to get into the sector. “Prices are getting bid up like crazy,” he says.

It’s competitive, but Sonne has identified a potential snag with investors who are unfamiliar with the industry: Current negativity about commercial real estate can be inappropriately applied to self-storage. “We have to educate people to overcome this bias up front,” he says. “We have a two-page pandemic writeup in front of our proposals with bullet-pointed facts and figures on how self-storage has performed.” This has saved them some trouble, but sometimes it can still take a Zoom call to get people comfortable.

“There have been tremendous losses in other sectors such as hospitality, retail, and office,” Sonne says, “yet, like in other downturns, self-storage outperforms other CRE. It can be hard for some banks and investors to get their arms around the strong performance of self-storage.” Making the case, therefore, requires a significant amount of data in real time. “Data that is 90 days old is not acceptable. Those using the due diligence reports want data that was updated today,” Sonne says.

So, what’s on the horizon? Sonne believes there are two unknowns to watch out for when performing due diligence going forward. The first is the potential for increased regulations with the new administration. “I think we’re going to see regulatory changes that could impact a lot of things, such as taxation and a change in capital gains,” he says. “The second is the general economic condition. We saw a lot of unemployment through December and the outlook is not promising for this year. Because of the lag effect, we’re going to start feeling the economic impact of the pandemic in 2021, but it’s hard to know the depth of it.”

Nitzberg agrees that it’s difficult to say when we can return to business as usual. “I’ve been in the business 28 years and we’ve had disruptions in the past, but they were very small, very localized, and very short-lived,” he says. “We’ve never had a pandemic. This is unique.”

Whatever the impact on the economy, self-storage has emerged and is at present as a stronger asset class than ever, which means there are more deals on the horizon. Pogoda says due diligence will begin to move again in a normal timeframe at some point, whether it’s in April, in the fall, or into 2022. “But for now,” he says, “we are doing things differently.”