Is Industry Consolidation On The REITs’ Menu?
Self-storage is a maturing industry that is gradually coming under the control of large operators while attracting new sources of funds from sophisticated investors. As self-storage evolves into this larger, more sophisticated model, there is a general belief that industry consolidation is inevitable as larger players continue to absorb the facilities of smaller owners.
In the true sense of industry consolidation, the large fish get fat by gobbling up smaller fish. Eventually, the industry is controlled by a few major brands, with the remaining companies vying for market niches.
As we’ve seen in most cases, self-storage is a different animal. Some experts say the industry is so fragmented with one- and two-store operators that storage consolidation may not resemble that of other industries, such as hospitality. Plus, single-store entrepreneurs may be building faster than large operators can acquire them.
The industry may have to redefine the meaning of consolidation. It may be a matter of semantics, or just how you define the word “consolidation.”
“Most people think of consolidation as large companies getting larger,” says Dean Jernigan, CEO of Memphis-based Jernigan Capital. “If that’s the way you think of consolidation, yes they’re going to keep getting larger. Now whether the denominator grows faster than they can buy and have true consolidation, it will depend upon the year and that denominator.”
Jernigan is referencing the equation that determines the percentage of the storage market the REITs and other large players control. When the total number of storage facilities in the denominator (the bottom half of the fraction) grows faster than the number of large operators’ holdings in the numerator (the number above the line), then the REITs’ ownership percentage slips. If the reverse happens, that would be an indication of consolidation.
Is Consolidation Inevitable?
The industry is heading toward inevitable consolidation in the views of most Real Estate Investment Trust (REIT) executives as well as other professionals. “I believe you will continue to see further industry consolidation either financially, though acquisitions, or operationally through third-party management services,” says Spencer Kirk, CEO of Utah-based REIT Extra Space Storage. “The smaller owner/operators are recognizing it is difficult to compete with the REITs for customers online. As that realization sets in, you will likely see more of the smaller owners either choose to sell or align themselves with a REIT to manage their facility.”
Jernigan, the former CEO of Pennsylvania-based CubeSmart, has carried the banner for industry consolidation for two decades, predicting the trend at trade shows and other forums.
“I compared it to the hotel sector in the 1980s when Hilton, Marriot, and Holiday Inn looked like what I envisioned storage to be 10-15-20 years out,” Jernigan says. “We’re going to have a few big players and not that many small entrepreneurs flying their own flag. If you don’t have a brand that keeps you on the first page of Google at all times, you’re going to struggle to capture customers.”
Consolidation has winners and losers, and representatives of smaller operators are urging people to tap the brakes on this kind of talk.
“This theory that REITs are the bogeymen that are coming to gobble up the entire industry and that small operators can’t compete is one that has been propagated to create fear within the industry,” says Bill Hipsher, CEO of Omaha-based Storage.com. “I don’t know that it’s as legitimate as everybody wants to believe because it doesn’t fit their long-term business plans.”
REITs remain profitable by operating primarily in strategic pockets in high-density metro areas. But facilities outside the top 50 Metropolitan Statistical Areas (MSAs) in the United States are usually not REIT targets for acquisition.
“A lot of facilities that are found outside those markets aren’t attractive to REITs,” Hipsher says. “It’s hard for them to find the same economies of scale. That doesn’t fit with that large owner/operator model.”
Aaron Swerdlin, executive managing director of the NGKF Self Storage Group in Houston, partly supports this argument by pointing out that even though the REITs have been in an expansion mode since 2010, these acquiring organizations are not necessarily intent on consuming the competition. “The REITs have been more disciplined in this cycle than in the previous growth cycle,” Swerdlin says. “The REITs are doing a much better job of saying no to deals and letting the developer prove lease-up rather than betting on their ability to lease up marginal properties.”
The REITs have been more willing to engage in merchant building projects where developers take on the lease-up risk by constructing facilities and holding them for a short period. Once the facilities open or reach stabilized occupancies, the REITs often will pay a premium to acquire the stores and eliminate much of the lease-up risk.
Consolidating The Numbers
To have true consolidation, the largest operators should continuously be acquiring facilities faster than can be added to the total mix, but the numbers indicate that hasn’t happened historically in storage. Industry data indicate the ratio of public-to-private ownership has not changed much in the past 20 years. According to statistics provided by New York REIT Sovran Self Storage, public REITs controlled about 11 percent of the 25,000 storage facilities in the U.S. in the 1990s. With the number of facilities growing to more than 53,000 since then, the ratio of REIT ownership has not increased significantly.
Ken Nitzberg, president of Devon Self Storage in Emeryville, Calif., contends that the percentage of inventory owned by public companies has gone down for every five-year period going back two decades, even though the individual companies have grown.
“The reason is most of the development comes from the entrepreneur side, not the REITs,” Nitzberg says. “The REITs’ strategy is they’re more than happy to buy your store you built and filled. They will continue to buy, but they aren’t major developers and builders. The top operators can’t buy enough to keep pace with the industry’s growth, so their percentage of ownership will continue to shrink while their total number of stores will continue to rise.”
Westport Properties’ President Charles Byerly, who believes the industry has been in consolidation for more than 20 years, observes a similar pattern. “If you look at the top eight operators, they’ve all grown. They are consolidating assets,” Byerly says. “But when you look at their overall market share, it hasn’t gone up as much as anybody would have thought. You would have thought that the top operators would have controlled a much higher percentage of assets and they don’t.”
Jernigan notes there wasn’t true consolidation from the 1990s to 2010 because of the glut of new facilities. That changed, however, beginning in 2010. Jernigan says only 300 facilities were added in the top 50 markets between 2010 and 2014.
“Consolidation started to happen in the sector when we weren’t building anything,” Jernigan says. “Clearly, large companies over that five-year period bought more than 300 properties in those top 50 markets. We had true consolidation for the first time. But in years past, the denominators kept getting bigger. Large companies kept getting larger, but there wasn’t true consolidation.”
Despite considerable acquisition activity over two decades, the self-storage industry remains highly fragmented nationally. According to Mini-Storage Messenger’s 2015 Top Operators survey, the 10 largest operators own approximately 13 percent of the storage facilities, with regional operators and small entrepreneurs owning the rest of the stores. This fragmentation should give well-capitalized operators an opportunity to target individual properties and portfolios at attractive cap rates.
Given the number of properties already owned by management groups and the publicly traded REITs, some investment experts estimate there are still 20,000 storage facilities that can be acquired. Considering that these four REITs currently own fewer than 5,000 storage facilities, the REITs could potentially tap into this large pool of assets and grow substantially.
Byerly views industry consolidation as a bifurcation process where sophisticated platforms are active making acquisitions while also providing third-party management for smaller operators that can’t keep up with the operational expertise that’s required to compete in the Internet age.
“There’s a lot of folks that are aging out; they are not willing to give up assets but they’re going to give up the work. Those groups will seek out third-party management,” Byerly says. “You will see bifurcation lead to more consolidation from an operational perspective. I think you will see a lot of flags change over the next 10 years and you’ll see larger operators come out of that.”
Third-party management is one method the REITs employ to earn revenue and get their foot in the door for future ownership. For big operators, third-party management represents a pipeline for future acquisitions.
Private operators are turning to third-party management to take advantage of revenue management software, online expertise, and call center technology that the REITs offer. Many operators could find themselves at a competitive disadvantage without this assistance.
“Ultimately the exit for people building new sites faster than REITs can gobble them up is to get them leased up and stabilized and either in the hands of a REIT or another well-capitalized buyer,” says Shawn Hill, principal at Chicago-based The BSC Group.
Some private operators employ the strategy on a grander scale by building up their portfolios and selling them to larger operators. For example, Morningstar Properties of Matthews, N.C., sold large portfolios to Public Storage in 2006 and again in 2013. Morningstar is back to building a new portfolio of facilities once again.
New Building Boom
Complicating the consolidation issue is the growth spurt that is expected to continue through 2020. Positive metrics for storage, coupled with population growth, lead some experts to believe that the industry can comfortably handle 500 new facilities a year to accommodate the growth.
Some predict that rapid self-storage development could conceivably increase the number of facilities to more than 60,000 in 2020, according to “The SpareFoot Storage Beat.” This could put a serious crimp in the consolidation talk.
“True consolidation is coming to an end over the next few years because we’re wrapping up the first year of a development cycle and next year we’ll have more properties coming online that big operators don’t own,” Jernigan notes.
But long-term, Jernigan indicates that consolidation is a foregone conclusion, primarily because of the Internet. “We thought when Google search first came out that it was going to level the playing field, but it hasn’t. It has tilted it even more in favor of large players because they have the budget and people and expertise to stay relevant with Google at all times,” he says.
Jernigan contends that even in markets where REITs may not have a major presence, their websites still pop up on the first search page because of their nationwide search engine optimization (SEO) efforts.
“Consolidation is going to continue in a big way with large companies getting larger and small entrepreneurs having trouble competing for the customer because of Google search,” Jernigan says.
Not So Fast
Many smaller operators refuse to surrender to big players and they have found ways to remain viable amid all the consolidation conversation. “There are definitely pockets and markets within the U.S. where competing against REITs is more difficult if you’re not being proactive in finding ways to compete with them,” Hipsher says, “but it doesn’t mean they’re not beatable.”
Hipsher maintains that Google and other search websites make it easier for small companies to compete compared to five years ago. That’s because search engines are now more sophisticated in helping consumers find the best local business that fits their specific needs, regardless of size.
“Today if a local website is optimized for local search and SEO, whether they’re a small operator or big operator, search engines are working hard at serving up the most relevant results based on location,” Hipsher says. “It’s not always going to be the biggest, it’s going to be what’s nearest that is optimized for search engines.”
By using the services of Internet marketing companies, Hipsher argues that smaller operators can spend half of what large players pay per facility and show similar results. REITs have to manage a large nationwide network of websites, whereas the smaller company only has to focus on one or two facilities.
“They can be very specific in optimizing for a single facility and it will probably be much less expensive than trying to operate this massive site where you have to keep feeding the beast and the small operator doesn’t have to do that,” Hipsher says. “For anywhere from $500 to $1,200 a month they should be able to find a solution that helps them be just as if not more competitive as the large operator.”
A Different Evolutionary Path
True industry consolidation may be years off, but many storage experts look at major metros and see consolidation already taking root.
“Our five public equity REITs and U-Haul now may own 10 to 12 percent of all facilities, but if you look in the largest markets, that number is substantially higher,” Jernigan says. “If you look at the top 25 markets, public companies own probably 20 percent of those markets if not 25 percent.”
REITs are better equipped to overcome the various barriers to entry in the largest markets. Very different dynamics are taking place in large markets, according to the Self-Storage Almanac. “First, the larger operators prefer these metro areas because they are able to get the highest rents in the market, often coupled with higher occupancy rates,” according to the Almanac. “Second, because the larger operators are typically better capitalized, they can afford to pay higher land costs to develop and higher acquisition prices to purchase facilities in these markets.”
The consolidation trend starts in the largest markets and soon we may see its influence seeping into smaller territories.
“Where you have seen consolidation is in the top markets and that is bleeding into secondary markets,” Hill says. “Ultimately it may not be a situation where the REITs control everything, but my personal belief is that well-capitalized, sophisticated buyers with very sophisticated revenue and operational management and marketing will dominate the landscape in the next decade.”
Virtually all industries evolve toward consolidation, almost as if it’s the natural order of things. The market doesn’t seem to tolerate a proliferation of onesie-twosie operations, as the gravitational pull of a large entity is much too captivating.
Self-storage consolidation appears to be taking a different evolutionary path from most of its business counterparts, but the result may eventually look similar.
Guy Middlebrooks, CubeSmart’s vice president of third-party management, sums up consolidation this way: “We believe that consolidation will continue, but new development will most likely outpace consolidation.”
Although that seems to be a non sequitur statement, it perfectly paints the convoluted picture that is consolidation in the self-storage industry.
David Lucas is a freelance writer based in Phoenix, Arizona. He is a frequent contributor to all of MiniCo’s publications.