By Taylor Williams
A number of economic, demographic and bureaucratic headwinds are propelling investment in self-storage properties across Texas, such that some brokerage firms are on pace to have record-breaking deal volumes in 2021.
Last year, the outbreak of COVID-19 postponed the typical leasing season of late spring and early summer. Individuals and businesses grappled with economic uncertainty by tightening their purse strings. But by fall of last year, leasing and occupancy rates had rebounded, making it clear to investors that self-storage assets tended to flow cash better than other property sectors. Consequently, a number of players shifted out of asset classes like retail, office and hospitality and into the more stable self-storage space.
The early months of the pandemic also coincided with the natural tapering off of the development cycle in Texas. Numerous submarkets in major Texas cities had become overbuilt in the years leading up to 2020, and COVID-19 served as an additional governor on new supply, further bolstering leasing velocity and rent growth. And as the federal government pumped trillions of dollars of aid into the economy, ushering in a new era of inflation, investors were able to adjust their revenues to cover rising costs with ease.”
Lastly, the election of President Joe Biden in November 2020 stimulated investors’ fears that a hike in the capital gains tax rate or a serious amendment to the 1031 provision of the U.S. tax code — or both — could well be imminent. As such, sellers across all property types, including self-storage, found an incentive to accelerate their timelines for bringing their assets to market.
It all adds up to a thriving investment sales market for a property type that not so long ago was reeling from oversupply, rental rate stagnation and targeted property tax increases — at least in Texas.
According to data from Marcus & Millichap, at the midpoint of this year, the U.S. self-storage market had posted a 3.4 percent year-over-year increase in rent growth. The national vacancy rate fell by 20 basis points during that period and now sits at about 7 percent, which represents a 15-year low.
Consequently, deal volume is up in 2021, as are sales prices. According to Marcus & Millichap’s data, the average sales prices for the 12-month period ending in March 2021 was $117 per square foot, a 6 percent increase year-over-year.
The answer to the question of which of these factors bears the most responsibility for the elevated deal volume depends on who you ask. But all sources interviewed for this story agree that some combination of the muted supply gains, steady cash flows and shifting investment preferences is laying the groundwork for record transaction volumes in 2021.
What New Investors Like
Like any new endeavor, investing in self-storage properties comes with a learning curve. And brokers have been all too happy to educate first-time investors on why self-storage is currently a great place to park their funds.
“Self-storage offers more flexibility than other hot property types like industrial and multifamily because storage tenants are on short-term, month-to-month leases,” says Danny Cunningham, director of the self-storage division in Marcus & Millichap’s Fort Worth office. “So owners can be more dynamic with their pricing and adapt more quickly to economic changes.”
Flexibility is a good thing to have when inflation hits. The U.S. Consumer Price Index posted 5.4 percent year-over-year increases between both June and July of this year and last year. Both of those figures represent 13-year highs for the de facto inflation gauge. On a relative basis, this feature makes self-storage appealing to owners of retail or office properties whose tenants were locked in to long-term leases and found their businesses — and ability to pay rent — decimated overnight by the once-in-a-lifetime global health crisis.
“With storage, your biggest line item is usually your loan, and right now that’s a cost that you can lock in at a historically low rate,” says Steve Mellon, managing director at JLL’s Houston office and leader of the firm’s national self-storage group. “And on the revenue side, you can adjust your street rates and move your in-place tenants up to market rates very quickly.”
How to Win a Deal
Cunningham says that his firm is seeing more first-time buyers enter the market, and that he expects his team to have its best year ever in terms of both dollar value and transaction volume.
“To give an idea of how aggressive the market is, we closed more deals above list price in the first half of this year than we have in the last 10 years combined,” he says. “And while there are more first-time buyers, more often than not, investors that are winning deals are the large regional and national private capital groups that have connections to institutional funds or smaller local and regional groups that are backed by high net-worth individuals or friends and family money.”
But although rookie buyers, such as locally based private investors, may be well-funded and in some cases backed by private equity, they are often still at a disadvantage when it comes to winning deals, says Mike Mele, head of Cushman & Wakefield’s national self-storage advisory group.
“Other than price, winning bids usually come down to track record and the ability to close,” he says. “Sellers are looking at how many deals a buyer has already closed on, how quickly they perform due diligence and what their history of re-trades is. So local buyers have a tough time competing with REITs and private equity groups with established track records because sellers know that those buyers can get the deal done.”
Mele says that over the last seven years, his team has closed an average of 41 to 48 deals per year. This year, it’s already closed 45, a testament to motivated sellers and a crowded and hungry buyer pool.
“We see bids come in right on top of each other, and we want to give everyone a fair shot at the deal,” concurs Michael Johnson, associate at Texas-based brokerage firm Bellomy & Co. “So it’s tough to make those calls to buyers that came in second or third place. We know they sincerely want to buy the property and have put their best foot forward on pricing and terms, such as a shorter due diligence period, no-financing contingency and in some instances nonrefundable earnest money.”
Seeing buyers improve their letter of intent (LOI) terms and put down nonrefundable earnest money are byproducts of the new market dynamic, sources agree. In addition, Johnson says, some sellers are drawn to buyers that make a point of physically touring the property — something that was largely unfeasible a year ago.
“We’ve definitely seen buyers get more comfortable getting on planes and touring sites in person this year,” he says. “Every property is built a little differently, and for some sellers, knowing that a prospective buyer has put boots on the ground and physically viewed the asset creates a sense of comfort.”
Hustling to Close
Across all property types, many commercial investors suspect that adverse changes to the capital gains and 1031 components of the U.S. tax code are coming — it’s just a question of when. As such, some brokerages are seeing deals come in spurts as investors speculate differently on when the changes will happen.
“The potential threat for changes to capital gains laws and 1031 exchanges kept us really busy in the first quarter as sellers sought to lock in at current capital gains rates,” says Johnson. “That activity has slowed a bit, but when you combine that expectation with how much cap rates have compressed, it becomes a big motivator for sellers. If they’re going to pay taxes on a sale, better to do it now, because those tax rates aren’t going to decrease.”
Conversely, Mele of Cushman & Wakefield says that he expects these concerns to drive more deal volume in the second half of this year, which he anticipates will be followed by a slowdown in the first half of 2022.
“Markets aren’t totally convinced that anything is imminent with 1031s, but it just makes sense not to press your luck right now,” he says. “There are a lot of owners in Texas that have held their properties for many years and put off the sale. But now they’re hearing about these changes, and that should make for a very busy second half of the year.”
As for what could prevent that scenario from coming to fruition, Mele points to the possibility of the Federal Reserve raising short-term interest rates to curb inflation, thus making acquisition financing more expensive for buyers. He also sees the potential for “buyer fatigue,” meaning that investors may simply lack the time and manpower to vet and pursue all the deals they want. But Mele says the market has not yet reached that point.
Mellon of JLL agrees that there could be some logistical challenges to maximizing deal volume before the end of the year. Specifically, he believes the industry has a “human resource problem” in the sense that many of the ancillary players involved in a deal — surveyors, appraisers, inspectors — are understaffed and behind on their workloads. If these labor-related problems persist, it could lead to buyers getting more selective about which deals they pursue.
“When you look at all the steps required to complete a transaction and consider the labor aspect, almost everyone is behind,” he says. “So buyers may get more choosey about where they’ll spend their time. With deals for properties in good locations with stable cash flows that are easily understood, there will always be plenty of interest because those deals can be underwritten quickly.”
“But for deals that have some ‘hair’ on them, like an easement or a lack of cash flow because the facility just opened or a unique condition demanded by the seller — some investors aren’t focusing as much on those as they were earlier in the year,” he continues. “Because there’s just so much product to choose from.”
— This article originally appeared the August 2021 issue of Texas Real Estate Business magazine.