What’s it worth?
That’s the ultimate question when it comes to determining valuation for developments and for sales and acquisitions in self-storage and all other classes of real estate. Getting the right answer involves answering a complex series of other questions.
Chris Sonne, executive vice president and specialty practice co-leader for self-storage for Newmark Valuation in its Irvine, Calif., office, confirms the basic elements that must be analyzed to come to a realistic valuation, whether for a prospective development or the sale or acquisition of an existing facility, include appraisals; net operating income; interest rates; capitalization rates (calculated by dividing a property’s market value by its NOI); location and demographics; market type; occupancy; entitlements; and right-of-way.
Current market conditions are uncertain in a rare or even unique way because of so many troublesome converging factors, all of which can affect development and existing property valuations, says Sonne, who has worked in the industry for nearly 40 years and seen many economic cycles’ effects on self-storage. These factors include rising interest rates, which generally create an inverted yield curve, meaning short-term rates are higher than long-term rates on treasury bills. This usually means a recession is coming; some argue that’s the case, but others say no because of strong job growth.
The current economic climate is unusual “because of more challenges at once than we’ve seen before,” Sonne says. These are inflation, the pandemic, social and political unrest, the war in Ukraine, global pressures heightened because of supply chain disruptions caused by the pandemic and by international relations and trade agreements and the reduced ability to transport materials. This can slow the pace of development and increase costs, “and suddenly you see profits dwindle. … But we have a massive amount of what they call dry power, or capital—money—to invest. And so, people have to place that money and get a return on it somewhere.”
Sonne says despite the different predictions about whether a recession looms, it’s important to consider the employment participation rate, which is down by 4 million people from before the pandemic. That’s important because it’s partly the reason for low unemployment figures, which don’t necessarily mean “the economy is zooming” but do mean more people who want jobs stopped looking.
“The participation rate is really important, because that’s 4 million people not paying taxes and not putting money into to the economy,” Sonne says, “… and I think the Federal Reserve know that. They’re looking at those things, too. But they’re concerned. Inflation has declined slightly but they’re going to continue raising rates until inflation goes down, and that’s really the only way to beat inflation.”
Because interest rates are higher compared to a year ago, cap rates typically will increase and valuations decrease, he says. A cap rate has two components: debt (affected by the interest rate) and equity—“what the return on equity is, what people put in.” Equity return is decreasing. Because confidence in self-storage remains strong in boom and bust markets compared to other real estate types, cap rates are increasing more slowly than interest rates are.
“I’m talking about stabilized, operating facilities,” Sonne says. “With projects for development, interest rates are even more impactful because the cost of money goes up so much higher than it was that some projects that maybe were feasible may not be feasible today due to higher interest rates.”
Valuation starts with a trade area’s market conditions, especially for proposed new construction but also for existing facilities, he says.
“Is that trade area oversupplied, undersupplied or (at) equilibrium?” Sonne says. “If it’s oversupplied, you’re going to fight on rates and occupancy. It’s going to be a battle. So that might reflect your risk analysis, where you pay a higher cap rate. You might be in the same city and across town and you might be in an undersupplied trade area where you have positive existing customer rate increase potential, and that might be a different risk parameter. … So, for a proposed facility, uncertainty in the economy causes investors to be more cautious. Confidence is great for value; uncertainty is not so great.”
Newmark Valuation has seen transaction volume decrease by 5% to 25%, Sonne says, and rising interest rates are partly the cause. Buyers don’t want to pay more, so sellers might take their properties off the market.
Interest rates have been the biggest factor affecting valuation, says Cory Sylvester, principal at New York City-based Radius+ and principal at Albuquerque, N.M.-based DXD Capital. Rising rates have caused “a dramatic shift in the valuation of the clearing price for what developments and acquisitions are trading at,” Sylvester says. Many factors that affect valuation are related and complicated. A cap rate, for example, includes NOI and occupancy, among others.
Rental rates and occupancy are the two main factors affecting valuation, he says. Appraisals are not fundamentally necessary for valuation. Valuation is what the market clears at between a buyer and seller—“what people are willing to pay”—which is affected by capital markets, especially the cost of capital, which has risen steeply. The extent to which the rising cost of capital has affected valuation “has been hard to understand because you haven’t had a lot of price clearing in the market because of how disconnected it has become.”
“Sellers generally are selling because they have to, not because they want to,” Sylvester says. “The prevailing methodology I think most people adhere to is that the interest rate environment is transitory in nature. So, if I can wait, I should, because the cost of capital should come back down … which would do the opposite to what valuations are at today. The cost of capital has to do with both equity and debt. Availability of debt because of how fast interest rates have gone up has created a lot of economic strain, which has reduced lenders’ willingness to provide debt capital, which has further strained the number of available buyers for these properties. Any time you have a constraint on the number of buyers, it produces pressure on the clearing price.”
Cash flow is the foundational measurement to determine valuation, says Paul Fiorilla, director of research for Yardi Matrix.
“Obviously that’s the most important thing,” Fiorilla says. “Another key consideration is the amount of storage per square foot in the submarket you’re in, because one of the unique things about storage is that stock is not evenly spread out like other asset types, such as multifamily or retail.”
Self-storage rents rose significantly in 2021, he says, but that growth has decelerated. Yardi Matrix’s November 2022 report shows that the national average street rate in October for all unit sizes and types decreased 0.7% annually to $145, the lowest point so far in 2022.
“Operators are still doing well by increasing rates for existing customers as they’re rolling over their leases,” Fiorilla says. “So, the cash flow of storage operators is still OK. But if the economy weakens, if consumers cut back … anybody developing any sort of real estate right now has to moderate their expectations about future rent growth.”
Development-financing costs have probably doubled since the start of 2022, and fewer banks are making loans, Fiorilla says. Big banks are doing little new lending “as regulators are on their backs about avoiding non-income producing loans as the economy is projected to go into a slowdown.”
“Commercial real estate has historically had high default rates during recessions,” he says. “Plus, supply chain and labor issues have complicated development timelines and added to the expense.”
Another metric used to determine valuation is other properties’ value in the area in question, Fiorilla says. For example, properties in New York City are worth more than in Dubuque, Iowa, because New York City has higher rents and higher costs generally.
The amount of per-square-foot storage in a given submarket is also an important factor, he says. Some parts of the United States have more penetration per square foot than others, primarily in Sun Belt markets. For example, Charleston, S.C., has more than 11 square feet of storage per capita. This compares to less than 4 square feet per capita in New York City.
The pipeline of new self-storage supply as a percentage of current inventory rose 20 basis points in October from September, according to Yardi Matrix’s November report. Combined, projects planned or under construction are equivalent to nearly 11% of existing stock. Fiorella says he expects that percentage will decrease over the next couple of years as new development gets harder and more expensive.
But overall, self-storage is on solid ground, Fiorilla says. Demand would probably hold up even if a recession hits unless the downturn is especially steep. Sonne says self-storage “is kind of slow and steady. It’s not the sexiest asset class … but it’s steady.”
Donald Jones, owner of Donald Jones Consulting & Service LLC, based in Fort Worth, Texas, has worked in self-storage for 29 years and opened his business 19 years ago. He says the road to an accurate valuation passes many signposts. These include knowing your competition and how your development, sale or acquisition fits into the overall market in question and showing a realistic expense valuation.
If you’re competing against a REIT, for example, understand how it operates day to day and figure out how to take advantage of its methods. Companies with 100 or more locations operate using the same formula no matter where the facilities are located. REITs typically try to maintain the market’s highest rates, which could help smaller operators set their rates to maximize lease-up.
Occupancy is a key factor in determining valuation, Jones says, but missteps in measuring it are common. Occupancy is divided into three types: units occupied, square footage occupied and economic occupancy. In doing his self-storage consulting work, Jones doesn’t use computer-generated reports.
“I go out and physically check the competition myself,” he says. “I just did it in in Lake Charles, Louisiana. I’ll do it in Mississippi in a couple of days. I want the information. I’m the one who’s going to define what the value of a property is, and I’d better get it right. People may lie to themselves about how fast they can lease up their facilities, (make assumptions through) rose-colored glasses. I’ve represented every side of it—the bank, the appraiser, the seller, the buyer, the developer, the investor and even the property manager trying to figure out what to do with their life.”
If you have an appraiser who hasn’t talked with you about your deal, then you’ll get undervalued, Jones says. The appraiser should know your financial model, though by law an appraiser is not supposed to be influenced by you. Informing the appraiser verbally about your deal while exerting no influence is the goal.
Jones say that, as a third party, “I’ll get appraisers call me and ask if this makes sense. … There’s a lot of people who need to evaluate it.”
Valuation For Development Vs. Sales And Acquisitions
The speculative nature of development makes it “much more risky,” and it makes reliable valuation more difficult, Sonne says.
“With existing properties, you can look at typically three years of income and expense history,” he says. “What is their effective gross income? Sales and acquisitions can have metrics applied to them. So, it’s less risky. They say for development you can’t do too much due diligence. Developers able to build now have been successful, though (there have been) fewer new projects.”
Any development deal “must rest on its own merits,” Jones says.
“Essentially, you are selling a picture,” he says. “The real valuation is what someone is willing to pay. Will the seller be selling a set of plans? Will they be selling a permitted set of plans? Will they be selling a property that will be delivered and sold at certificate of occupancy? These are all important. For me personally, I don’t think they have anything to do with existing properties.”
Jones says that if he is working with an existing property with three to 20 years of history, “I am going to hold that owner accountable for true valuations, not guesses.”
“If the property is super successful, they will get the lowest cap rate,” he says. “If the property is a garbage pile, the cap rate will go up. If a property has upside potential, they might pay a little more than the true valuation.”
What People Sometimes Overlook
Whether with developments or sales and acquisitions, people sometimes overlook the importance of market conditions and financial analysis, Sonne says. They tend to do the financial analysis but don’t adequately analyze the core market conditions of the trade area in question.
“If it’s oversupplied, you could do all the financial analysis you want and show terrific returns on paper, cash flows and show terrific yields,” Sonne says, but if demand is insufficient, then “you could build it but nobody would come.”
“It is common sense, but sometimes they say, ‘Ours will be brand new and better’ but dismiss lower quality facilities down the street” that might not have as high quality, he says, “but customers don’t dismiss it. They’re going to analyze their rate. Let’s face it, it’s a garage, a 10×10 unit. Sure, it’s a new and nice facility, which does matter for competitive position, but I don’t think you can dismiss it if you’re class A compared to class C.”
Developers tend to overstate time to lease-up and rates and overlook the need for the right unit mix for the market because they’re uninformed, Jones says. Careless buyers will overlook these factors because of insufficient due diligence. And “the cost of construction is a serious problem. … There are three deals today that I am working that are all heavily delayed because we do not have the materials to finish.”
In-House Vs. Third-Party Valuation
Self-storage has had a lot of new investors the past two years, Sonne says. But those who have built the best new projects and made the best buys have a lot of self-storage experience.
“If you’re new, getting outside due diligence is a big help,” he says.
Sylvester says that, generally, unless you invest sufficient time to understand the nuances, “I think it generally makes sense to use pros to help guide you through that process. Fiorilla says companies with sufficient staffs typically do their own valuations, whereas smaller companies with fewer employees might hire third-party companies for valuations. Sometimes, though, bigger companies might want a second opinion by hiring a third party.
“Banks should always require a third party to analyze the information,” Jones says, for both development deals and sales and acquisitions. “I don’t think banks have the information they need to determine a project’s viability. … Any group that is going out to raise money should have the blessing of a third party for their investors. If you have never built, you should be asking for help.”