Redefining Core Real Estate:  Investing in the New Reality

By H. Michael Schwartz, Chairman and CEO of Strategic Storage Trust, Inc, and R. Christian Sonne, Managing Director of the Self Storage Industry Group for Cushman & Wakefield

At the heart of real estate investing theory is the idea that you can generate relatively strong returns with less risk by building a portfolio of diversified “core” assets. The traditional definition of the core asset class has been narrowed down to four basic property types: office, industrial, retail and multi-family housing. However, as the recent recession has taught us, these commercial assets are far less resilient and more volatile than anticipated.

So perhaps it is time that investors begin to broaden their perspective on what qualifies as a core real estate investment in terms of real world performance. Based on the most common characteristic of this class, one of the first places they should look is the realm of self storage.

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, TALF-eligible CMBS transactions.  The asset class is defined by steady cash flows, 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% from 2001 to 2008, according to a survey by the Self Storage Industry Group at Cushman andWakefield.

The resilience of self storage isn’t the only reason this property type should be considered a core real estate investment. By almost every measure that is used to define 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:

• Stability
• Consistent      cash flow
• Potential      for capital appreciation
• Hedge      against inflation
• Solid      returns (well above bonds)
• Modest      risk (well below stocks)

The self storage industry has been the fastest-growing sector of theU.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 first 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 %.  Demand has obviously kept pace with the growth of supply.

Self storage also provides an excellent inflation 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 inflation 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.

Average returns for self storage assets are well above bonds.  For example, annual dividends of self storage REITs currently range from 3.26% to 10.92% with a fourth quarter average (2009) of 5.70%.  Comparatively, long termU.S.30-Year Bonds were 4.19% andU.S.10-Year Bonds were 3.39% as of October, 2009 (Moody’s Bond Record).  Corporate Bonds (Baa) returns were 6.29% in the same period.  If single self storage assets are considered, an overall capitalization rate (national average) is 8.75%.  Moreover, credit risk for self storage is spread among hundreds of tenants, reducing the chance that the loss of one major tenant will affect income.

Even in terms of asset characteristics, self storage fits the bill for a core asset. A recent study by a team of researchers from Lend Lease Real Estate Investment defined core real estate investment as minimizing risk under the characteristics of both the asset itself and the entire portfolio. Core assets were identified as investment with these qualities:

• Existing      buildings
• Substantially      rented
• Orderly      lease roll over
• High quality
• Limited      to just the four basic property types (office, retail, multifamily,      industrial)
• Low      leverage
• 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 definition.

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 significant debt (near $100,000,000) in 2009 – the revised balance sheet resulted in significant 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% loan to value at a 7.25% rate for five years with 25 year amortization for recourse loans.  Other assets have challenges of tenancy and cash flow related to the economy making financing extremely difficult to obtain.

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 below), self storage has outperformed all sectors (office, retail, industrial and apartments) in a five-year, 10-year 15-year annual return.  In addition, self storage offered a lower standard deviation over all property types in a five-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.

About the Authors

H. Michael Schwartz is CEO and Chairman of the Board of Strategic Storage Trust, Inc. (SSTI) — a publicly registered non-traded REIT targeting the self storage market.  Mr. Schwartz has been an officer and director since SSTI’s first initial formation. He has more than 20 years of real estate, securities and corporate financial management experience.  Prior to SSTI, Mr. Schwartz was the Managing Director for Triple Net Properties, LLC. (now an indirect subsidiary of Grubb & Ellis Company). In addition, he served on the board of the firm’s affiliated broker-dealer, NNN Capital Corporation (now Grubb & Ellis Securities, Inc.).

R. Christian Sonne is Managing Director of the Self Storage Industry Group for Cushman & Wakefield. An appraiser and real estate economist by training, Sonne started Self Storage Economics in 2002 because of the growing sophistication of the self storage asset class and market demand for quantified self storage data and conclusions. Self Storage Economics became Cushman & Wakefield’s Self Storage Industry Group in 2006.

**To review the expanded article, please visit www.strategicstoragetrust.com

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