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Many investors
struggle with the decision to develop a self-storage property from
scratch or acquire an existing site. Their answer is likely to be
a matter of economics, but additional considerations should be included
in the analysis.
This
trite but true real estate notion of “location, location, location”
could never be more important than in consideration of self-storage
ownership. A mature firstgeneration store can easily compete with
a state-of-the art property if its location is superior. Conversely,
a poorly located store, such as one in an industrial park or at the
end of a cul-de-sac, can be buried by a development project in a locale
with higher traffic and better visibility. No sacrifice should be
made when it comes to location quality.Most
investors would argue the choice to develop or acquire is driven by
one of the purest of economic theories: risk vs. return. The following
juxtaposition outlines the benefits and drawbacks involved in acquisition
and development. A case could easily be built for either strategy.
Return
Buy.
There are few “deals” in the current market. In fact, it’s
a seller’s market. Capitalization rates have never been lower
(or prices higher), and thus returns for most projects are weak. Should
a buyer elect to buy at a very low cap rate (7 percent?), all will
be well—as long as cap rates remain low and continue to decrease.
If cap rates rise, as some investors predict, buyers could face problems.
The increase may outrun any gains in income from rental-rate increases.Anticipated
returns for an existing property may be down 10 percent to 12 percent
cash-on-cash, and internal rates of return may be in single digits.
It should be noted that the ability to leverage existing properties
at a higher initial level than development sites affects this analysis.Build.
All-time highs in vacant-land costs coupled with unprecedented increases
in raw materials and supplies have eroded developers’ yields.
Despite this diminution in profits, the “pay day” in self-storage
lies in new builds. The increase in value from vacant land to an operating
business is substantial and almost always outperforms acquisition
targets.Pro
forma returns for development projects (including the difference in
leverage) are considerably higher than for acquisition. In fact, good
development projects offer an infinite level of return at retirement
if construction financing is in place, allowing the project to develop
mature cash flows. Even with conservative pro forma incomes, most
development projects will offer cash-on-cash returns in excess of
20 percent and internal rates of return at least in the mid-teens.
Risk
Buy.
Typically, acquisition occurs after a project has reached stabilization.
Given this assumption, the buy target has a “proven” market.
Historically, unless there are extenuating circumstances, physical
occupancies do not significantly erode over time. In fact, rental-rate
growth provides for increased gross potential income and, ultimately,
greater profit and value.The
lack of available properties means the location risk is typically
fixed for buy targets. Since most markets do not offer a selection
of acquisitions in various locations, “what you see is what you
get” sites make this a static analysis. Great concern should
be given to projects in sub par locations.Product
type, including amenities, may be fixed or limited by the physical
attributes of the existing site. Demand for features that are not
practical or possible at an existing property may put the site at
risk. For example, if a facility cannot provide climate-controlled
space, it may be unable to meet the needs of the market. A buyer should
forecast the need for amenities that might increase costs, for example,
the addition of individual door alarms.Build.
The inherent risk in development projects is the length of rent-up.
The projected time to achieve stabilized occupancy is nothing more
than a guess, hopefully an educated one. Pro forma lease-ups vary
from market to market, depending on project size and type. They can
range from 12 months, which is rare, to 48 months.One
of the beauties of the development opportunity is the ability to select
the “right” site. While this is tempered by availability,
if the risk is too great, the developer has the option of looking
for an alternate location.A
“clean sheet of paper” in the development process allows
new projects to meet current demand. It can also produce designs adaptable
enough to meet future market needs and shifts at relatively low cost.
Flexibility in the development plan may allow for the addition of
amenities at less expense.
Deployment
of Capital
Buy.
Aside from risk adversity, the capital component is the largest advantage
of existing projects. Typical leverage of up to 80 percent of the
purchase price is available in acquisition financing. This lower capital
requirement may allow the investor to spread risks over a wider variety
of projects and locations. Sponsor quality and experience is not typically
the driving influence for acquisition lending.Build.
One of the most significant barriers to entry in the development of
self-storage projects is capital intensity. While every situation
is unique, typical leverage requirements for a development project
range from 65 percent of cost to 75 percent of appraised value at
completion of construction. The level of leverage and comfort with
the developer is typically dependent on the proven abilities and experience
of the sponsors.
Personal
Guarantees
Buy.
It is customary for acquisition loans to offer long-term, nonrecourse
financing in which the strength of the property and proven cash flows
are the primary strength of the loan. This may mean less stringent
requirements on the borrower with regard to credit worthiness, financial
strength and experience.Build.
While the value of a project must substantiate the lending decision,
the primary criteria for construction lending are often based on the
strength of the developer. This requires the sponsors to possess financial
strength, development and/or construction expertise and experience,
as well as a strong self-storage background. While not all-inclusive,
this summary of salient differences in the buy vs. build decision
can help. It is simply a matter of risk vs. reward.
RK
Kliebenstein is the president and CEO of Coast-to-Coast Storage, a
self-storage consultancy firm. From feasibility studies to financing,
Mr. Kliebenstein has a wide range of experience and expertise in development
and acquisitions. He can be reached at 877.622.5508, ext. 81.
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