By Taylor Williams
As commercial property types go, self-storage is considered one of the toughest to sink in times of economic hardship. As Texas and the United States enter the eighth full month of the COVID-19 pandemic, this quality is beginning to show through.
Natural disasters like floods and hurricanes tend to be windfalls for the asset class, as displacement from homes and damage to commercial properties raise short-term demand for self-storage. A pandemic does not have quite the same effect on the property type, especially when residential landlords in the United States are legally barred from evicting tenants.
But for the major self-storage markets of Texas, COVID-19 has generated some positive results. COVID’s impact on self-storage is somewhat similar to Hurricane Harvey’s impact on the Houston multifamily market in 2017, which was also overbuilt and saw an overnight boost in occupancy as a result of the storm cutting into supply.
In essence, COVID-19 has served as a mechanism to bring supply-demand balances closer to equilibrium. Because prior to the pandemic, the development pipelines in the major cities of Texas were peaking, creating oversupplied markets that were defined by sluggish rent growth, concessions and high levels of competitions for new entrants.
COVID-19 has served to lessen some of the oversupply concerns in major markets by causing some new construction projects to be put on hold or scrapped entirely.
Bill Brownfield of Brownfield & Associates, the Houston-based affiliate of Argus Self-Storage Advisors, says the perennial demand generators of job growth and in-migration are also helping to ease supply concerns.
“Supply-demand balances in Houston and other major Texas markets are headed toward stabilization,” he says. “It’s just a question of how long it will take to get there, and our best estimate is 18 to 24 months.”
Brownfield notes that self-storage developers and operators in Texas have long been aware of supply glut, and that before the pandemic, lenders had begun to pull back on financing for new construction. That trend should continue through 2021.
“As long as REITs continue to hold off on new development, which should occur for the foreseeable future, and banks are prudent about lending, then the biggest risk for self-storage for the next couple years is moving behind us,” he says. “Now it’s just a matter of absorbing the overbuilt space.”
Sources agree that in general, oversupply is a greater threat to the health of the self-storage industry than COVID-19.
“The only thing that gets in the way of storage is storage itself,” says Dave Knobler, first vice president investments in Marcus & Millichap’s Houston office and a director of the firm’s Self-Storage Division.
“You could have a flood, a hurricane, a pandemic — self-storage always has a way of wiggling out of trouble and even thriving in those situations,” he says. “But it can’t combat oversupply, and the Texas markets are littered with groups that developed facilities with certain rent expectations and are only hitting two-thirds of those projections.”
Mike Mele, vice chairman at Cushman & Wakefield and head of the firm’s National Self-Storage Advisory Group, echoes this sentiment.
“The biggest issue with storage before the pandemic was overbuilding, and that hasn’t really changed because of COVID-19,” says Mele, who works out of the firm’s Tampa office. “Properties that opened pre-pandemic have probably had more difficulty leasing up as quickly as their owners thought they would. For non-stabilized properties, you need more move-ins. But some of these places would’ve been in trouble without COVID, so we’ll see if they lease up and get rents to where they anticipated them to be.”
In Houston, Knobler says, there is “real caution” among developers. And according to Brownfield’s data, there is only about 1.5 million square feet of new product in the development pipeline. Of that total, only about one third is actually under construction. Much of that activity centers on expansions of existing facilities in fringe submarkets that are operated by major players like Public Storage and Morningstar.
The amount of new product in the pipeline represents just 2.4 percent of the total inventory of 63 million square feet and falls well below annual averages for Houston.
Year-over-year through June, rental rates for climate-controlled space and non-climate-controlled space in Houston are down 3.9 percent and 3.5 percent, respectively, according to Brownfield’s data. However, soft rates are still a reflection of multiple years of persistently robust development activity, which is now bottoming out.
In markets like Dallas and Austin, declines in self-storage development may be slightly less pronounced due to the healthy volumes of apartment communities and more dense developments like suburban mixed-use planned projects that continue to pop up across these cities, says Justin McCarthy, principal at Dallas-based Merriman Anderson/Architects.
“Projects aren’t completely drying up just because we’re in a recession,” he says. “Based on the amount of apartments that are being developed and the large mixed-use tracts and projects being planned, self-storage is still going to move forward to the extent that land is available. Right now it’s tough to find locations and pricing that make land deals for this product type come to fruition.”
“However, we’re seeing and working on storage as the leading development on parcels within planned developments in north Dallas, west Fort Worth and North Austin, among other places, and seeing suburban areas around San Antonio be explored as opportunities for the project sector,” he adds.
McCarthy says that with regard to his firm’s REIT clients, Merriman Anderson/Architects is currently doing more self-storage design outside of the Texas markets than within them. This is mainly due to land constraints, plus a wait-and-see approach to the recent rental slow down due to what mostly believe is caused by COVID-19 and quantity of development in the last five years.
Merriman Anderson/Architect’s clients also include private equity firms and local builders that hold their properties for the long term.
A Different Cycle
In addition to helping push the supply-demand needle closer to the center of the scale, the pandemic has uprooted the typical self-storage leasing cycle, coinciding with key months in which facilities historically see occupancy rates rise and move toward stabilization.
Federal legislation that was enacted amid the pandemic has had some impact on occupancy rates in the self-storage space. A moratorium from the CDC and the Trump Administration on single- and multifamily evictions, which is now in effect through the end of the year, has negated the leasing activity that typically comes from renters moving out or downsizing during times of economic hardship.
On the flip side, the cancellation of in-person classes at a number of colleges and universities across the country means that the typical fall move-out season will be slower than usual, so self-storage units that might normally be vacated may instead stay occupied.
Between these and other forces, the typical ebbs and flows of occupancies at self-storage facilities have been completely scrambled in 2020.
“The traditional leasing season this year was paused and delayed for two or three months, so markets have had some pent-up demand from the shutdown in March and April,” says Michael Johnson, principal at self-storage brokerage firm Bellomy & Co. “Leasing began to rebound in May and June, but the biggest uptick came in July, and carried into August. So we’ve basically had a full leasing season compressed into two months as we now enter the traditional move-out season.”
“From an operations standpoint, COVID-19 did shorten the traditional lease-up season, when people are typically moving in the late spring and summer months and put some belongings into storage,” adds Knobler. “So we could have move-outs in fall that weren’t offset by move-ins in spring and summer, but we don’t expect rents to increase much or for owners to be heavy-handed with rates in the current environment.”
Although leasing activity has been strong in recent months, self-storage owners remain wary of losing customers by pushing rents during times of high unemployment. However, facilities that are newly opened and are still in lease-up are under greater pressure to boost occupancies amid the
Strong leasing activity of late has rejuvenated the cash flows of many self-storage properties. This trend, combined with interest rates that are still at historical lows, has spurred investment activity during those months. Capital markets experts in the self-storage space expect that level of investor demand and confidence to continue through the fourth quarter of 2020.
“Any assets on the market right now that are flowing cash are generating a lot of offers,” says Mele. “Because operations have maintained constant flows, self-storage has become very much in demand from a transaction standpoint. There are investors that want to get into this space as a backstop against problems in other asset classes, so we’ve seen some cap rate compression.”
“A number of deals that fell apart in March and April are starting to come back full-circle,” adds Johnson. “CMBS financing was basically nonexistent at the beginning of the pandemic and has taken some time to get back into the game, but with conventional acquisition loans, terms are still very attractive. It’s a great time to be a buyer.”
Bellomy, which has been very active in the Houston and Austin markets recently arranged the sale of three facilities totaling 1,807 units throughout Austin to owner-operator Storage Star. Since mid-June, the firm has closed several other deals in the greater Austin and Houston areas, including sales of a 192-unit facility in Lago Vista and a 235-unit facility in Spicewood, two cities located north of Austin. The buyers in these transactions represented a mix of institutional, private and Texas-based capital.
Brownfield notes that a “real bifurcation” exists with regard to the availability of debt for stabilized properties versus those that are still in lease-up mode. He also estimates that cap rates for facilities still in lease-up mode have increased by 100 to 200 basis points during the last six months due to uncertainty caused by the combination of COVID-19, leasing’s higher risk and soft rental rates.
For some owners of properties that are still moving toward stabilization, the best option may be to hold and wait for excess supply to be absorbed and for positive rent growth to resume. While lenders are, as a general rule, returning to the self-storage market, they are generally not financing new construction projects. The lack of capital for new development should minimize competition for owners that are still in lease-up mode and enable them to start moving toward their desired rental levels.
“We are still selling some deals in lease-up command decent prices — not below replacement cost or below construction cost — but those are probably still trading below what owners projected when they did their initial pro formas,” says Mele. “On those deals, sellers can get out whole or with some profit, but it’s usually not enough for developers that have worked hard on a project for five years and want to turn a profit.”
With certain types of lenders like CMBS getting back into the space, more financing options are available to borrowers. Johnson says that in this low interest-rate environment, investors are generally seeking to lock in long-term, fixed-rate debt with nonrecourse provisions, with unusually high requests for interest-only deals.
“The biggest thing borrowers are demanding is interest-only, whether it’s two years, five years — we’ve even seen a couple scenarios where lenders gave 10 years of interest-only payments,” Johnson says. “You can make a lot of deals pencil with those kinds of terms, and that’s helped buyers meet sellers’ expectations on pricing and get deals done.”
Self-storage properties in Texas continue to field demand from a diverse pool of buyers, much as they have in past years, but some groups are undoubtedly being more aggressive than others in the current climate. While REITs typically have the financial advantages to win deals they really want, sources note that most of these institutional groups are abstaining from new acquisitions due to greater economic uncertainties that have their shareholders nervous.
Knobler’s team recently arranged the sale of Big Space Storage, a 279-unit facility in Houston. The deal generated six offers in 12 days — a testament to the extent to which capital sources are getting back into the game. The facility was built in 2016 and had thus achieved steady occupancy, illustrating how demand is somewhat skewed toward stabilized assets.
His team also recently put a deal under contract for a property in Houston that received 15 offers, most of which were from private equity groups, which are often sitting on large reserves of capital that need to be deployed.
“Private equity has grown in this space exponentially over the last three years and is very competitive with cautious REITs for new deals,” says McCarthy. “But REITs continue to buy the assets that were developed by private equity, as we continually see sales and deals on projects we have under design, construction or have completed within the previous 12 months. Our private equity clients are consistently developing with future sales in mind, not for a collection of assets similar to our REIT partners.”
Markets are also seeing stronger pushes to buy from high-net-worth private investors and syndicators.
As for sellers, many are waiting to see if the trend of positive leasing activity will continue through the rest of the year. However, given how many sellers’ have seen pricing adversely impacted by oversupply in recent years, they may not need a ton of coaxing to pull the trigger on marketing their properties for sale.
“Owners remember how oversupplied the market was in 2019 — in those days, if they could get their heads above water, they’d exit,” says Knobler. “The owners that are in lease-up and can’t yet get their price are going to hold on. But if we continue to see absorption of units and upward movement of rental rates, a lot of owners will be enticed to sell.”
— This article originally appeared in the September 2020 issue of Texas Real Estate Business magazine.