A Look At Lease-Up Trends
Last year, Memphis-based Jernigan Capital Inc. funded a couple of properties in Central Florida. The two self-storage facilities opened for business in late April and early May of 2016 and both are near stabilization.
“The properties could stabilize by spring or early summer, which would effectively be a one-year lease-up,” notes John Good, Jernigan’s president and chief operating officer. “Generally, across our investment portfolio we underwrite new development to a three-year to four-year lease-up. The experience in these Central Florida projects indicates, at least in those markets, that leasing trends are still relatively strong.”
If one looks across Jernigan’s portfolio of projects that have opened in the last year, most of them are trending at or above our projected three-year lease-up rates. There are a couple of exceptions, projects in the North that opened off season where it is still too early to tell how strong that leasing is.
“Projects we have opened in southern markets are generally exceeding projections in terms of the pace of leasing,” says Good, reiterating, “we’re still seeing in most of the markets in which we have invested lease-up going very strong.”
Self-storage performance is dependent on what is happening economically in a relatively small catchment area, sometimes just within a three-mile radius, so it is hard to postulate how good lease-up trends are nationally. That’s particularly true in the current market when there has been a spate of new construction–nothing like the 2,500 facilities added to the national count in the years before the financial crisis, but 600 to 800 new stores a year is nothing to brush away.
So as Guy Middlebrooks, vice president of third-party management at Malvern, Pa.-based CubeSmart, observes, “lease-up trends will continue to be dictated by supply and demand in a particular sub-market.”
Although it’s hard to generalize about the country as a whole, Kenneth Nitzberg, chairman and CEO of Devon Self Storage Holdings LLC in Emeryville, Calif., suggests a less aggressive leasing posture for owners going forward as a great majority of all the overbuilding from the mid-2000s was absorbed between the years 2010 to 2015, and now the industry has started to see new building at a significant level once again.
“If you have a store in a strong population market, with few competitors, it should lease up fairly well,” Nitzberg adds. “However, if you are building into a market that is way over-served, you could be in a world of hurt.”
Big Market Slowdown
At the end of 2017, MJ Partners Real Estate Services, Chicago, reported Public Storage, the behemoth of the self-storage space, had a development pipeline larger than 10 to 15 years ago, and that the various facilities currently in development by the company totaled 4.1 million rentable square feet estimated to cost $520 million, and various expansion projects totaling an additional 1.1 million rentable square feet estimated to cost $140 million.
If Public Storage and other big, aggressive self-storage companies, spread new development across the country there would be little concern about regional over-building, but most new construction is heavily concentrated in certain A-markets such as Denver, Miami, Houston, and Dallas.
“San Antonio is right there along with Dallas and Houston in terms of submarkets flooded with new product,” notes Ann Parham, president and CEO of Joshua Management in San Antonio. “The interior of San Antonio has seen a lot of new construction and some expected projects that haven’t even come out of the ground yet.”
This isn’t to say there are A-markets that haven’t been over-constructed with self storage.
“Several A-markets continue to have plenty of capacity for self-storage development,” says Good. “I look at our projects in Orlando and Tampa and those projects have leased-up incredibly fast in big markets with over two million population each. The same is true for Atlanta. We have two projects in the Atlanta area that have exceeded expectations in terms of lease-up. We have not felt compelled to go to secondary or tertiary markets to find submarkets where we can build storage and lease up quickly.”
New construction will affect lease-up in particular locations, Nitzberg concurs. “What happens is that a micro-market gets overbuilt, and when that happens the smaller players tend to compete for tenants by dropping rents and that hurts everyone. I don’t think we have seen much overbuilding yet, but we have a great deal of talk. If 100 projects are planned I would be surprised if more than half actually get built.”
Jernigan Capital is carefully watching for pockets of overbuilding. “If you build in one of those submarkets with too much new construction you could end up disappointed in the pace of lease-up,” says Good.
Charles Byerly, president and CEO of US Storage Centers, Irvine, Calif., says, while there hasn’t been overbuilding “across the board,” he has seen some crowding in markets with a lot of new supply.
“If we sustain this type of growth in terms of more new supply it will put pressure on some of the bigger markets,” he says. “When you start adding multiple stores, it does put pressure on things. We are now starting to see new construction in smaller metros, suppliers are getting calls for work in secondary markets.”
Parham would agree. “You still have mom-and-pops that are looking to build on land they own somewhere out in the country as opposed to the big players who are concentrating in the city areas where the potential for growth is highest.”
She adds, “It will be harder to maintain that sharp lease-up pace because you have more competition. That’s the nature of the beast. So, what you do is try to put your next facility in a place where you would be able to maintain in the face of competition, where if someone builds another 85,000 square feet it won’t kill you.”
The idea, of course, is not to build in a slim market, which is easier said than done. “Good development options are getting harder and harder to find,” says Parham. “I could build all day long, but finding the dirt is hard at this point.”
Balancing Lease-up And Revenue
The key reason for all the new construction is that demand is outpacing supply. Even without doing statistical analysis, that’s an easy phenomenon to observe. Leasing trends over the past three to four years have been so strong and steady that, as Middlebrooks notes, “existing self-storage assets have experienced the highest occupancy levels in the history of our industry. Demand continues to be strong. There is not a lot of runway left for REITs to increase occupancy in their same store pools.”
“Runway” is a term you should hear a lot of in the coming year; it refers to the existing units that still need to be leased. As Byerly notes about US. Storage Centers, “We have a little runway left where lease-up could continue.”
Byerly also says, in terms of occupancy, his company is at capacity. That’s not a contradiction as experienced self-storage operators prefer to manage to around a 90 percent occupancy, because they are balancing revenue as well. At 90 percent occupancy, good operators prefer to raise rates as opposed to keep filling boxes.
“We’ll push harder on rates if occupancy starts coming up beyond 90 percent,” says Byerly. “For us, we try hard to keep occupancy around that 90 percent mark. There is room to go higher, but we are rate driven at that point.”
Looking at the occupancy rates from the publically-traded REITs, it’s obvious these big companies operate similarly. All the companies posted about 90 percent occupancy in 2015 and barely moved the needle in the subsequent year: Public Storage – 93.9 percent occupancy in 2015, 93.7 percent in 2016; Extra Space – 92.8 percent occupancy in 2015, 92 percent in 2016; CubeSmart – 91.6 percent occupancy in 2015, 91.8 percent in2016; Life Storage – 90 percent occupancy in 2015, 90.4 percent in 2016; and National Storage Affiliates – 88.5 percent occupancy in 2015, 88.4 percent in 2016.
“The bigger players all use some kind of revenue management system,” observes Nitzberg. “They are aggressive at raising rates and do a good job. When you get down to the midsize and smaller operators, who are typically in secondary and tertiary markets, they normally use a revenue management system and thus lag far behind the rental rate curve.”
So many smaller operators focus on occupancy because that gives them bragging rights, Nitzberg adds. “However, if you are at 97 percent occupancy, it tells me that you are not charging high enough. That means you haven’t raised your rents significantly and often.”
In the storage industry 85 percent occupancy is considered stabilized, but if a store gets above 90 percent that’s really good because that extra five percent goes right to bottom line.
“If you get much above 90 percent, what that tells me is not that you are in a strong market, necessarily, but that you aren’t raising rents aggressively,” says Nitzberg. “Self-storage is made up of 30-day leases, so you can raise the rents selectively and carefully every 30 days if you have the demand. What our industry is famous for is everyone comparing to each other on occupancy. I don’t know how to take occupancy down to the grocery store and buy dinner. You need revenue. So, you have to manage to your total revenue. Obviously, occupancy is major part of that equation, but I rather my store show 85 percent occupancy at an average of $1.50 a square foot than 90 percent leased at a $1 a foot.”
For a stabilized store, Nitzberg typically budgets about a five percent rate increase a year. Last year, for his stores where he had year-over-year comparisons, revenue grew by seven percent, but NOI (net operating income) grew by 19 percent.
“You got to watch your expenses like a hawk,” Nitzberg cautions. “If you were to graph how storage facilities perform, once you hit sufficient revenue to cover operating expenses any additional increase, with minor exceptions, falls to the bottom line. That’s why a seven percent increase in revenue translates into a 19 percent increase in bottom line profit, because all the costs were covered before the rental rate increases occurred.”
Again, looking a MJ Partners study of the publicly-traded REITs, there are two things to note: revenue and operating income follow Nitzberg’s dictum about revenue transformation, and the “runway” might be closing because those big leaps in revenue and operating income have been decelerating, on a quarterly basis, for about a year now.
For example, Public Storage portfolio revenues peaked at 6.8 percent in second quarter 2015, then ended 2016 at 4.6 percent; Extra Space portfolio revenues peaked at 9.9 percent in the third quarter 2015, then ended 2016 at 5.2 percent; CubeSmart portfolio revenues peaked 8.4 percent in first quarter 2016, then ended the year at 5.8 percent; and Life Storage portfolio revenues peaked 8.6 percent in the second quarter 2014, then ended 2016 at four percent.
In regard to net operating income, Public Storage experienced its peak at 10.4 percent in the first quarter 2016 before slipping to 5.1 percent at the end of the year; Extra Space hit apex of 12.6 percent in third quarter 2015 before dropping to 7.8 percent in third quarter 2016; CubeSmart boasted 12.9 percent in first quarter 2016 before ending the year at 8.1 percent; and Life Storage notched 10 percent in second quarter 2014, sliding all the way to 3.7 percent at the conclusion of 2016.
It will be hard to lift revenue and net operating income without significant rental rate growth, which, in itself, will be affected by slowing lease-up trends at existing self storage.
CubeSmart’s Guy Middlebrooks comments, “Rental growth will most likely be slowed in markets with new product being delivered. Otherwise, we expect to find opportunities to increase rates but not as aggressively as in recent years.”
Rental growth will slow only because the pace of the last few years was so high it was not sustainable.
“I don’t know if rental rates are getting better if you are talking about year-over-year growth,” says Byerly. “It’s been so good for the last five years it has gotten harder to keep up that sustained trend. When you compare self-storage to other property types, self-storage rent growth trend lines look very strong. There’s probably another year or two of good times ahead on that front until you see enough new supply come on board from a macro perspective.”
Rental rate deceleration can be attributed to new supply in some metros, namely the Texas markets, but “You can also argue the pace was so strong for a couple of years, unprecedented in fact, that deceleration was inevitable,” says Good. “The pace of rent growth in self-storage during 2014, 2015, and the first half of 2016 was never going to be sustainable over the long term–in self-storage or any other property type.”
As to that seven percent to eight percent rent growth over three to five quarters, no property sector has experienced that for a prolonged period of time. At some point the market was going to revert to the mean. The long-term average in the self-storage sector has traditionally been in the four percent to five percent range. The publically-traded REITs’ guidance for 2017 was in that four percent to five percent range.
Of course, there are some economic quirks, local and national, that could change the equation for self-storage.
Down in Texas, a number of counties have raised taxes. “Tax rates have gone up in select counties and that forces everyone to increase rents to pay for those taxes,” says Parham. “Even though Texas doesn’t have income tax, we have property taxes and we have seen a big jump in that over the last couple of years.”
Nationally, in March, the Federal Reserve raised its benchmark rate for the second time in three months, with the uplift in the 0.75 percent to one percent level. The Fed expects to stay on pace for similar rate rises through 2017.
Although, rates are still historically low, if you, as a self-storage developer, have a financial underwriting model that is very sensitive, with slim margins, if you are forced to go up another 25 bps (basis points) to 50 bps on a loan, that could, just as an example, require you to put another $1 million of equity into a project that you don’t have, thus ending your dreams of another self-storage development.
As Nitzberg notes, “A lot of stuff being bandied about is not going to happen.”
That can ease the specter of overcrowding self-storage in a few too many local markets, letting lease-up continue where there is still runway left on a store and allowing rental rates to continue moving up, albeit at a slower pace.
Steve Bergsman is an author, journalist, and columnist. His stories have appeared in over 100 newspapers, magazines, newsletters, and wire services around the globe; and his most recent book is “The Death of Johnny Ace.”