Redefining Core Real Estate: Investing in the New Reality
H. Michael Schwartz and R. Christian Sonne
In this article, the authors suggest that investors seeking shelter from the recent economic storms would be wise to add self storage to their core real estate asset mix of essential building blocks for balanced and successful portfolios.
In today’s uncertain economic climate,
many real estate investors are looking for
low prices, consistent cash ow and a hedge
against ination. The consensus among most
analysts is that a balanced portfolio of
diversied “core” real estate assets oers
these attributes. Traditionally, the core asset
class has been narrowly dened as four basic
property types: oce, industrial, retail and
multifamily housing. However, as the last few
years of economic turmoil have demonstrated,
these commercial assets are far from
recession proof and more volatile than
anticipated.
So perhaps it is time that investors begin
to broaden their perspective on what quali-
es as a core real estate investment in terms
of real world performance. Based on the most
common characteristic of this class, one of
the rst places they should look is the realm
of self storage.
Self Storage Investing
A relatively new industry in terms of investment,
self storage has matured to the point
that even the Federal Reserve has recognized
it as a core asset by allowing self storage
properties to be leveraged in single sponsor,
Term Asset Backed Securities Loan Facility
(“TALF”) eligible commercial mortgage
backed securities (“CMBS”) transactions.
The asset class is dened by steady cash
ows, a low break even point, minimal capital
expenditures and no tenant improvements or
leasing commissions. Even during the economic
recession and capital markets depression,
self storage market conditions remain
fundamentally stable suggesting it is to a
large degree recession resistant.
Like all real estate, self storage soared in
value in the mid-2000s when money was
easy and cheap. As the capital markets froze
and capitalization rates started rising, the
value of self storage properties declined
along with other real estate investments.
However, net operating income in the industry
rose at a compound annual rate of 2.02
percent from 2001 to 2008.
1
The resilience of self storage is not the
only reason this property type should be
considered a core real estate investment. By
almost every measure that is used to dene
*
H. Michael Schwartz is CEO and Chairman of the Board of Strategic Storage Trust, Inc.—a publicly registered
nontraded REIT targeting the self storage market. R. Christian Sonne is Managing Director of the Self Storage
Industry Group for Cushman & Wakeeld.
The Real Estate Finance Journal
E Summer 2010
© 2010 Thomson Reuters
12
core assets, self storage performs as well or
better than most commercial real estate
classes.
According to The National Council of Real
Estate Investment Fiduciaries (“NCREIF”), the
expectations of a core asset are as follows:
E
Stability;
E
Consistent cash ow;
E
Potential for capital appreciation;
E
Hedge against ination;
E
Solid returns (well above bonds); and
E
Modest risk (well below stocks).
Self Storage Industry History
The self storage industry has been the
fastest growing sector of the U.S. commercial
real estate industry over the last 30 year.
According to the National Self Storage Association,
it took the self storage industry
more than 25 years to build its rst billion
square feet of space; it added the second
billion square feet in just eight years (1998–
2005). In the last two years, however, self
storage new construction has declined by an
estimated 75 percent. Demand has obviously
kept pace with the growth of supply (see
graph).
Historically, self storage market conditions
have remained fundamentally stable. The
national trend data shows some remarkable
results that explain the rise of the asset
class. Over the 14 year time frame, total supply
more than doubled from 3.31 square feet
of self storage space per person in 1995 to
7.03 square feet of self storage space per
person in 2008—a compound rate of growth
of 5.53 percent per year. Even while supply
doubled, national occupancy ranged from
82.90 percent to 89.40 percent with an average
of 86.72 percent. Moreover, the average
monthly rental rate for a 10 × 10 storage unit
went from $56.02 in 1995 to $83.54 in 2008,
a compound rate of growth of 2.90 percent.
Redening Core Real Estate: Investing in the New Reality
The Real Estate Finance Journal
E Summer 2010
© 2010 Thomson Reuters
13
In summary, the supply more than doubled
while vacancy remained relatively stable and
rents increased. This suggests a resilient asset
class. To test resiliency, a simple scoring
model is analyzed that sums rent and occupancy
to obtain a score for each year. The
data indicates that in the 2001 recession
year (U.S. economy), the score declined
only—3.35 percent to 138.80 from a score
of 143.61 in year 2000. The next year (2002)
the score increases 6.76 percent to 148.18.
This indicates the asset class is resistant to
recession.
Advantages of Self Storage Investing
Although not always evident, there is
potential for capital appreciation of self storage
properties, either through capital improvements
or value added services. Examples
of other sources of income include
ancillary sales of various items (such as
locks, boxes, tenant insurance services, etc),
mail centers and rental trucks. Some properties
can be expanded by adding more units
thus creating additional value.
Self storage also provides an excellent in-
ation hedge. A report recently published by
The Institutional Real Estate Letter said data
shows that assets with shorter lease terms
tend to provide the best ination hedge. Although
apartments typically rank high on this
list, the average stay at self storage facilities
is only 12 months and can be as low as three
to six months for students or military
personnel.
Rents are more easily marked to market
than other asset classes because demand
for self storage is a function of the local trade
area, typically within a three mile radius. And
because rents are fee simple and not leased,
the owner can increase them at any time to
reect the impact of ination. In fact, self storage
revenue enhancement programs are very
successful at raising rent—so much that the
rent for existing tenants is often higher than
the quoted street rate to new tenants without
a signicant impact to vacancy.
According to the Self Storage Association
fact sheet, 83.9 percent of all U.S. counties
(or 2,634 out of 3,141) have at least one primary
self storage facility. Because of the
relatively small property size and value,
investments can easily be spread across self
storage facilities nationwide, insulating your
investment from local or regional economic
forces. The tenant mix also can cover a
broad range of sectors from small business
to personal, including military and student—
all of which demonstrate dierent lease
characteristics which leads to a more orderly
lease roll over such as length of stay and
seasonal rollover rates.
Average returns for self storage assets are
well above bonds. For example, annual
dividends of self storage REITs currently
range from 3.26 percent to 10.92 percent
with a fourth quarter average (2009) of 5.70
percent. Comparatively, long term U.S. 30-
Year Bonds were 4.19 percent and U.S. 10-
Year Bonds were 3.39 percent as of October,
2009 (Moody’s Bond Record). Corporate
Bonds (Baa) returns were 6.29 percent in the
same period. If single self storage assets are
considered, an overall capitalization rate
(national average) is 8.75 percent. Moreover,
credit risk for self storage is spread among
hundreds of tenants, reducing the chance
that the loss of one major tenant will aect
income.
In addition, self storage properties have
one of the lowest rates of delinquency among
commercial real estate classes with just 2.39
percent currently in default nationwide. The
delinquency rate is currently 7.06 percent for
The Real Estate Finance Journal
The Real Estate Finance Journal
E Summer 2010
© 2010 Thomson Reuters
14
multifamily, 4.4 percent for retail, 2.97 percent
for industrial and 2.7 percent for oce.
2 The
number of CMBS loans that have been
referred to special servicers (delinquent and
defaulted loans as well as loans seeking
extension or modication) is approaching nine
percent currently.
Even in terms of asset characteristics, self
storage ts the bill for a core asset. A recent
study by a team of researchers from Lend
Lease Real Estate Investment dened core
real estate investment as minimizing risk
under the characteristics of both the asset
itself and the entire portfolio. Core assets
were identied as investment with these
qualities:
E
Existing buildings;
E
Substantially rented;
E
Orderly lease roll over;
E
High quality;
E
Limited to just the four basic property
types (oce, retail, multifamily, industrial);
E
Low leverage; and
E
Limited anticipated capital expenditure.
Of these, the only characteristic that self
storage lacks is that it does not fall into the
so called “four basic property types”—which
we argue is an outdated denition.
Self storage investors usually target existing
facilities that are substantially rented.
While recently constructed self storage may
take as long as three years to reach stabilized
occupancy, long run occupancy near 85
percent is typical over the long run. High
quality is not much of a factor in this asset
class; whether a storage facility rates as
Class A or Class B is not as essential to tenants
as it is in oce or retail properties, which
rely on client impressions or customer trac.
Even older properties can produce an attractive
cash ow.
Leverage, of course, is volatile. However,
due to the stability of the self storage asset
class, capital is available. For example,
U-Stor-It Trust recapitalized signicant debt
(near $100,000,000) in 2009—the revised
balance sheet resulted in signicant gains in
their stock pricing. Currently, banks and life
insurance companies are lending to self storage
with continued institutional investment
from retirement funds and Wall Street. Typical
terms for self storage lending now are 65
percent loan to value at a 7.25 percent rate
for ve years with 25 year amortization for
recourse loans. Other assets have challenges
of tenancy and cash ow related to the
economy making nancing extremely dicult
to obtain.
Another core characteristic that sets apart
self storage from other assets is limited
capital expenditure. Unlike oce, there are
no capital expenditures for tenant improvements
or tenant leasing commission expenses
and unlike apartments, there’s no call for
a cleaning deposit and repairs. All you need
to do is sweep the oor before the unit is
ready for a new rental.
At the heart of investing theory is the idea
that you can generate more return with less
risk by combining diversied assets in the
portfolio. A core based portfolio is no dierent;
the asset mix should be diversied both
geographically and demographically. In no
asset class is this more easily achieved than
the self storage sector.
The last decade has seen the phenomenal
growth of new self storage facilities, yet
demand remains healthy with the exception
Redening Core Real Estate: Investing in the New Reality
The Real Estate Finance Journal
E Summer 2010
© 2010 Thomson Reuters
15
of a few chronically over served trade areas.
Time and population growth are the biggest
drivers for recovery of over served markets
in self storage. New construction is at the
lowest point in a decade and the nation’s
population is expected to grow near 100 million
over the next two generations, suggesting
stability and growth for self storage in
future years.
The Real Estate Finance Journal
The Real Estate Finance Journal
E Summer 2010
© 2010 Thomson Reuters
16
Conclusion
Investors seeking shelter from the economic
winds of change would be wise to add
self storage to their core real estate asset
mix of essential building blocks for balanced
and successful portfolios. Based upon a
statistical analysis of NAREIT’s annual price
in total average returns by property sector
(see graph), self storage has outperformed
all sectors (oce, retail, industrial and apartments)
in a ve year, 10 year, 15 year annual
return. In addition, self storage oered a
lower standard deviation over all property
types in a ve year and 10 year period.
Therefore, institutional investors should embrace
self storage as a core real estate asset
class following the same path as Wall
Street.
NOTES:
1
According to a survey by the Self Storage
Industry Group at Cushman and Wakeeld.
2
September, 2009 by Trepp, Inc.
Redening Core Real Estate: Investing in the New Reality
The Real Estate Finance Journal
E Summer 2010
© 2010 Thomson Reuters
17
