Self-storage properties have had a pretty good run in Texas over the last several years. Surging population growth has brought more material possessions into the state, boosting absorption of existing space. In addition, ample land for development has enabled builders to bring self-storage — a submarket-specific business — to new, underserved communities.
The investment side of the business has flourished as well. A capital-rich environment has sustained a healthy pace of development and price escalation has kept cap rates low, incentivizing many owners to market their properties for sale.
The building boom is still running hot. According to Tennessee-based research firm STR, as of June 2018, there were more than 300 self-storage facilities in the development pipeline in Texas. In the 12 months leading up to that point, 72 new facilities totaling almost 7 million square feet came on line.
In addition, about 130 new properties are slated to open by June 2019, adding more than 9 million square feet, or 5.7 percent of the existing inventory. And those figures only encompass the seven biggest markets in Texas.
According to The Houston Chronicle, the Dallas, Houston, Austin and San Antonio markets all feature about 8 square feet of storage space per capita. By comparison, more populous cities like Chicago and Los Angeles only have about 4 square feet of storage space per capita.
Still, most self-storage experts in Texas concur that in major metros, the sector is peaking or has already peaked in terms of new development.
Dips in rental rates and increases in discounts and concessions to renters further suggest that the party is winding down. Hefty increases in property taxes, rising interest rates for acquisitions of existing properties and increasing construction costs for new projects are also contributing to slowed growth in the self-storage space.
A Renter’s Market
According to STR, average per-unit rents for both stabilized and new properties in the five largest Texas markets declined by 140 basis points between May 2017 and May 2018. As rents decline, operators are prioritizing occupancy and offering all manner of incentives to get units filled up.
Jeff Bailey, SurePoint Self Storage
“Pretty much every operator is conceding at least one month of free rent right now for moving in,” says Jeff Bailey, partner at SurePoint Self Storage, which has developed seven facilities in the Houston and San Antonio areas. “The strategy in today’s market, especially at larger facilities managed by third-party REITs, is to lease up quickly at all costs and then slowly increase rents over time.”
Bailey adds that his firm focuses on designing facilities whose unit mixes are geared toward occupancy, not long-term rent growth. That means catering the unit mix to the demographics of the trade area and doing whatever is necessary to lease the unit when a prospective customer walks in the door.
For larger self-storage operators, the threshold for increasing rents typically occurs at or around 90 percent occupancy. Furthermore, if a property sees all its units of a certain size or variety fill up, the owner will raise rents on those units rather than wait for the overall occupancy rate to catch up.
“REITs have to fill their facilities up, so they’re willing to offer more concessions than the average operator would,” says Ginny Sutton, executive director of the Texas Self Storage Association (TSSA). “In addition, the REITs are better equipped to handle the new supply because they can market so much aggressively and afford more discounting.”
According to local sources, it’s becoming increasingly common for operators of newly built facilities to put their properties on the market within a year or so of opening. Although these properties may be facing low occupancy and consequently, stagnant revenue streams, high pricing levels and an abundance of capital looking for placement can induce these owners to sell rather than hold. This is especially true for new facilities with heavy debt loads.
Michael Johnson, a broker at Austin- and Houston-based Bellomy & Co., notes that offering customers one or two months of free rent is fairly common at newer facilities that are still leasing up. Johnson says that with properties his firm is marketing, it’s become increasingly common to see vast discrepancies between underwritten pro-formas and actual rental rates. He attributes much of this disparity to oversupply concerns.
“We see a compelling pattern involving rents at facilities that have been open for about six months,” says
Michael Johnson, Bellomy & Co.
Johnson. “It’s like the underwriting took into account the impact that concessions and discounts would have on occupancy. But those incentives didn’t adequately gauge how many other new facilities were opening in that submarket.”
Johnson says that with virtually every property that Bellomy is currently marketing, a new competitor has either recently opened a new facility or expanded an existing one within five miles. This holds true for properties in both core urban markets and smaller, more rural areas of Texas.
Which is why the notion that self-storage is a three- to five-mile business is still applicable in today’s market. True, the amount of new supply the market can bear varies from submarket to submarket, but in order to avoid discrepancies between underwriting estimates and actual cash flows, it’s critical to know at all times who’s building what and where.
In 2017, Bellomy arranged the sale of this 1,111-unit facility in Dallas that is managed by self-storage REIT CubeSmart.
Property Taxes Weigh Heavily
Sluggish rent growth brought on by heavy development has limited net operating incomes (NOI) of self-storage properties. Constrained NOI has in turn been eroded by rising property taxes across the sector.
According to Sutton of TSSA, property taxes are a big enough problem to the point that they can sometimes dictate whether a self-storage facility is profitable or not.
Ginny Sutton, Texas Self Storage Association
“Property tax increases come in waves from one district to another, but when they hit they can be significant,” she says. “We’re talking about values for existing facilities that have doubled or even tripled. Some of our members have had their gross revenues from the first half of the year essentially wiped out by their property tax bills, and there’s very little margin for profitability when that happens.”
Sutton adds that the impact of property tax hikes has thus far been limited to a disconnect between buyers and sellers on pricing. But it’s only a matter of time before rising property taxes begin to scuttle overall investor demand for self-storage. With interest rates also rising, rampant increases in property taxes are bound to limit acquisition activity in Texas over the next couple years.
“We’re seeing investors that have been exclusively in Texas for decades start to look elsewhere,” she says. “They just can’t make it work here anymore.”
Bailey of SurePoint concurs with this view. “It’s hard to say how much of an impact property taxes have had on investor demand thus far,” he notes. “But it must weigh heavily on investors’ decisions. However, higher property taxes are also having an impact on new development as returns have diminished. Combined with construction price increases, it has become harder to develop in Texas.”
According to Gilbert Davila, principal at Popp Hutcheson PLLC, an Austin-based law firm specializing in property taxes, the hikes are primarily attributable to basic increases in construction and investment in self-storage properties across Texas.
Based on how pricing for commercial real estate in Texas has generally skyrocketed in recent years, appraisal districts are now able to derive very low cap rates for many of the properties they assess. In addition, Davila says appraisal districts are only just beginning to have access to comprehensive data to use in valuing properties in this sector.
Gilbert Davila, Popp Hutcheson
“Prior to the last couple years, appraisal districts weren’t very aggressive on self-storage owners, and now they’re playing a game of catch-up,” he says. “However, we should be past the worst of the exponential increases and should see more stagnant property tax valuations for the year 2018.”
Davila also points out that many self-storage owners are now protesting their assessments in court. Because Texas law requires all properties within a certain jurisdiction to be assessed equally and uniformly with facilities of similar sizes, this litigation should help lower the median level of valuation for self-storage assets.
Other Factors at Play
The dwindling number of sites in Texas that aren’t rife with nearby competition, as well as basic rises in land and construction costs, are helping to slow the pace of new development. Heftier interest rates should soon inflict similar impacts on acquisition activity.
But aside from these factors, which apply to all property types, there are a couple other forces that are choking off self-storage growth in Texas.
True, the overall volume of new development of self-storage in Texas has exploded in recent years. But the impact of so many projects on new supply has been augmented by the sizes of these new facilities, which are only getting bigger.
In Houston, ProGuard Self Storage recently opened a new facility in the Memorial City area. The property features approximately 270,000 square feet of net rentable space across 1,750 units. In Austin, The Jenkins Organization, a Houston-based developer, recently opened a 1,022-unit facility featuring more than 110,000 net rentable square feet. And in San Antonio, a joint venture between Austin-based HPI Real Estate Services & Investments and self-storage industry veteran Hugh Horne is developing a 979-unit facility with 134,000 net rentable square feet.
Self-storage venture HPI Horne is underway on this 979-unit facility in San Antonio, and is currently working to develop two more facilities in this market.
“Projects continue to get bigger and vertical, infill opportunities continue to be the focus for some developers,” says Bill Brownfield, consultant and broker at Houston-based Brownfield & Associates. “Investors still like urban cores because the deal sizes in secondary and tertiary markets are considerably smaller.”
Bill Brownfield, Brownfield & Associates
According to Brownfield, REITs are scaling down their acquisition activity in Texas, presumably due to soft earnings brought on by oversupply and the arrival of more private equity firms in the space. In turn, some lenders that have traditionally been bullish on self-storage are paring back their involvement in the sector.
“As long as there’s overall demand for investment in commercial property, self-storage will get its fair share,” he says. “But we expect the slow rent growth and concessions, as well as the threat of property taxes, to continue.”
— By Taylor Williams. This article first appeared in the August 2018 issue of Texas Real Estate Business magazine.