Planning Your Exit Strategy
By some reckoning, about 80 percent of the ownership of self-storage units are in the hands of private investors. The other 20 percent are under the stewardship of institutional investors, including real estate investment trusts and equity investors.
That overweighting has been tilting in recent years as REITs concentrate buying power and more and more equity investors pile into the sector. The changing ownership patterns have increased the importance of what has come to be called “the exit strategy”. It is more of a concept than a process, and more a timeline than a program, but buyers and developers are hearing the phrase more now than ever before.
“The exit strategy gives you a road map,” says Marc Boorstein, co-founder of MJ Partners Real Estate Services in Chicago. “The main reason for exit strategies is that some investors, especially private equity, have a time frame. They have a five-year fund or seven-year fund. The exit strategy says they will liquidate those funds at five years or seven years.”
“Going into a deal, you have to model some sort of hold and exit strategy just to give you an idea of what the all-in return would be on a specific investment,” notes Doug McCarron, a principal with Premier Storage Investors LLC in Thousand Oaks, Calif.
“If we work with clients who are just now building, we ask them what their goal is for building the property,” says Anne Ballard, president of Universal Storage Group in Atlanta. “Do they want to build and flip the property in five years, selling to a REIT? We make them think about an exit strategy, because if they think they will sell to a REIT, we have to build now to REIT standards to get the best possible price in the future.”
The relatively recent importance of an exit strategy in the self-storage universe has a lot to do with the changing nature of the business. As noted, there is still a high percentage of ownership with private investors, who tend to hold properties for generations. However, with prices at peak, capitalization rates low, and money cheap, even long-term hold owners are selling. Many of new buyers are equity investors, who tend to recycle capital about every five to seven years, hence the exit strategy.
REITs are also long-term holders. However, as Ballard notes, if you are developing for your own portfolio or you are a merchant-builder, you must consider a possible REIT acquisition exit strategy for that property, whether it is at the moment it receives a Certificate of Occupancy or five years into the future.
“When we talk to people coming into the industry and this is their first self-storage [facility], they often say to us ‘We would just like to build a small property’,” says Ballard. “We have to remind them as a part of their exit strategy they want to be in a good positon if something should happen and they need to sell, that the storage facility has to be 55,000 to 65,000 net rentable square feet for a REIT to look at it. It needs have certain attributes to get the best price. If they just want to build 100 units, no REIT will look at that. There will be no high price in the future.”
Growing For Higher
Many mid-size owners now have financial partners who are helping to fund growth. This money is not much different from any other type of equity play, which is to say it is recycled every five to seven years and is programmed to be meet certain criteria, chiefly an expected level of internal rate of return (IRR). New money and even the REITs tend to IRR benchmark their returns.
“Before you go into any investment, you have to look what you are buying and whether you can grow that cash flow over a set duration; next you need to model when you think you will exit and at what price,” says McCarron. “The majority of institutional investors are basing their investment decisions from an IRR perspective.”
The exit strategy is a concept, but some companies will formalize it. For example, if outside capital, especially pooled money or a fund, is investing $50 million in self-storage, that capital will require that within X years the investment will be liquidated and the investment will be given back with a return. For other funds, the exit strategy could be X-plus years, at which time the investment will be liquidated and hopefully the return meets set hurdles.
“The exit strategy is becoming more and more important for self-storage because there is more and more private equity through funds investing,” says Boorstein. “That is the major change in self-storage; with all this private equity money coming in, exit strategies have a lot shorter time frames.”
The exit strategy is less important for a public company because it doesn’t plan on a big sell-off, hence it won’t use a portfolio IRR.
“Some of the public companies will look at IRR because it is just a metric to compare investments, but there are some public companies that claim they have no exit strategy,” says Boorstein. “Everyone else will have an exit, because you do have to compare self-storage to other investments, whether it is cash, other property types, or non-real estate.”
World Class Capital Group invests in most real estate asset classes and has a portfolio of 61 self-storage stores that it operates as Great Value Storage.
“Our IRR strategy is case-by-case dependent on the market and the asset,” says Nate Paul, founder, president, and CEO of World Class Capital Group in Austin. “We don’t have a clearly defined corporate X amount of IRR. The nature of the business is the investor’s target above market IRR, but we see returns dependent on either acquisition or development and we are very active private developers. The investment return is higher when you develop.”
Kenneth Nitzberg, chairman and CEO of Devon Self Storage Holdings LLC in Emeryville, Calif., says, in the case of his firm, exit strategies are tied to several important factors: the anticipated ownership period of the company’s financial partners, where the market is at any given moment (There is such a huge amount of money trying to get into the self-storage sector today and, with cap rates low, it might be an excellent time to explore a sale.), and the tax laws (Will the tax brackets change in three years? Who knows.).
Nitzberg adds, “Our situation is different than many other self-storage operators as most of our partners are IRR driven; and when you calculate an IRR, your biggest single enemy is time. The longer you hold something, the more difficult it is to hit a higher IRR target.”
So Nitzberg has coined what he calls his “surrender theory”. He may have an exit strategy of five to seven years, but if a buyer comes along offering enough money, he might just surrender that property, thus the exit strategy will change. “The surrender theory takes your five- to seven-year anticipated hold and turns it into three years, because you got an offer that is simply too good not to take,” he says.
According to Paul, the right strategy is to have a “defined strategy” on the front end, but then be opportunistic. “For example, you may have a seven-year investment horizon but, as there could be attractive propositions that come earlier, you have to be flexible,” he says.
The term exit strategy taken at face value really means that one is giving up or “exiting” ownership of a particular asset or portfolio. In reality, there are numerous exist strategies, some of which allow for continued ownership.
When looking at exit strategies, there are multiple angles. “There’s the ability to sell assets on a one-off basis. There are portfolio sales,” says Paul. “For larger private operators, an exit strategy could be through eventual public offerings.”
National Storage Affiliates Trust of Greenwood Village, Colo., took this route going public in April 2015. As of the first quarter 2016, the company owned 292 stores with 17 million rentable square feet of storage space.
As the cost of capital is so low today, one popular exit strategy is not to sell at all but to recapitalize the existing loan. Nitzberg breaks down the strategy with this simple explanation: “You buy something for a $1 with a loan of 70 cents. It is a five-year loan. If, after five years, the asset is worth $2, you refinance with a new loan for $1. That reduces your leverage from 70 percent to 50 percent, plus you pull out your original 30 percent equity while still owning the asset.”
This does not create a taxable event and you should still be able to receive cash flow from operations, which is an effective yield of infinity as you have no original capital in the project.
Another variation from Nitzberg: “You can again finance at 70 percent of value, which is $1.40. Now you paid off the old loan, pulled out the original 30 cents of equity, plus another 40 cents. You still own the asset which is cash flowing. At that point, you are essentially playing with the ‘house’s money’ as you have no equity remaining in the investment.”
Nitzberg casts his company’s investors into two groups. The first, institutional investors that are typically tax exempt. This group doesn’t consider taxes as an issue and is strictly interested in the IRR. The second group is high net worth individuals and family office clients, who may own self-storage investments for decades. Today, this group is replacing their old six-percent loans with four-percent loans.
“You can put a bigger loan on the property, pull out significant capital, and yet have a lower monthly mortgage payment, thus generating more monthly cash flow to the investor,” says Nitzberg. “We have done several of these type deals in the past two years.”
One growing trend is the portfolio recapitalization; Paul says institutional and equity groups are offering capital for portfolio recapitalizations, which gives existing partners an exit strategy while the ownership is maintained. Several self-storage groups have taken this route of late.
Loosely defined, portfolio recapitalization happens when a capital source such as an institutional investor provides a large sum of capital which will allow the current portfolio owners to restructure the ownership of the underlying assets. It’s an exit strategy without exiting.
Simply Self Storage of Orlando counts 160 self-storage facilities with more than 12 million square feet. In January, the business press reported that Brookfield Asset Management Inc., Toronto, had agreed to buy the company, or at least 90 of the stores, for $830 million. Paul calls this move a portfolio recapitalization.
While REITs profess to not having exit strategies, these large publically-traded entities do provide the exit strategy for mid-size companies or funds that invest in self-storage.
Take the case of SmartStop Self Storage, Inc., of Ladera Ranch, Calif., which was initially formed as Strategic Storage Trust, Inc., a non-traded REIT. It owned and operated 160 self-storage properties. According to Boorstein, the company looked at numerous exit strategies, including continuing as a private company, filing for an initial public offering, or selling the company outright. In the end, it opted for a multi-prong approach.
Salt Lake City-based Extra Space Storage, Inc., bought all the stores in SmartStop’s Fund I, reports Joe Margolis, Extra Space’s chief investment officer. “SmartStop did a good job for the investors. It built a portfolio, liquidated it, and provided their investors with a good return. It was an appropriate time to harvest gains in that vehicle. SmartStop is still investing for its Fund II and Fund III.”
A company such as Extra Space can be very helpful to self-storage organizations that do have exit strategies. As an example, Extra Space can provide a number of tax efficient strategies for an exit through operating partnership units.
Margolis explains, “So many investors, who have built up a portfolio of assets, might have a low tax basis. Maybe they had ownership for a long time, depreciated the portfolio, and if they sell the asset for cash they have to pay capital gains tax. If they exchange that asset, transfer the proceeds into our operating partnership in exchange for units, that’s a tax-free exchange under the Internal Revenue rules. What they get is an OP (operating partnership) unit that mirrors a share of common stock. It gets the same dividend as a common stock and in the future, when they want to get out of the stock and go to cash, they can convert the OP unit to common stock and sell it.”
A lot of investors have issues about what happens if they sell. What do they do with the money? Here’s one answer.
“They could put it into an OP unit which produces a dividend yield, and they now have diversified exposure,” says Margolis. “Instead of owning five or 15 assets, they now have exposure across 1,350 units in 39 states. And they can get to control their exit.”
An Exit Strategy For Builders
Just as the REITs provide an exit strategy for funds and equity players, they offer the same opportunity to merchant builders as well under what is called the Certificate of Occupancy (C of O) program. For a number of operational reasons, REITs would prefer not to take on development risk, so they will contract with a merchant builder to develop; when the project is completed and the C of O has been achieved, the REIT will buy the property. Usually the price is discounted as it was contracted at the beginning of the program.
“Under C of O, the new buyer, whether it is a private or public company, won’t take the development risk, but it will take the lease up risk,” Boorstein comments. “The developer will find the land, entitle it, get a construction loan, and build. Once it completes construction and gets a C of O so it can open for business, a buyer will take them out–before any revenue. This program is dominating the conversations for new developments.”
Extra Space is very active with C of O deals, says Margolis. “It works for developers because they have an exit strategy: a sale. It works for us, because we don’t have to own the asset during development. We don’t take any development risk, cost risk, completion risk. We do take leasing risk, which we are comfortable taking given our understanding of those markets.”
Extra Space counts 21 C of O deals in its pipeline.
“If you rewind three or four years ago, the C of O exit was not an option unless you had a project located in a high barrier to entry market,” says McCarron. “There had been so little supply to come on line since the financial crisis that self-storage fundamentals are at a euphoric state. Now projects in some undersupplied markets are getting to 60 percent to 70 percent leased-up within an eight- to 12-month period. That provides a comfort level to participants who are buying an empty project.”
McCarron adds, “C of O opportunities are not going to work for every single market as some markets will eventually become saturated. From a macro viewpoint, as long as new supply stays in check, these deals will continue through 2016 and 2017.”
Steve Bergsman is an author, journalist, and columnist. His stories have appeared in more than 100 newspapers, magazines, newsletters, and wire services around the globe; his most recent book is “The Death of Johnny Ace.”