I was reminded by a friend and someone I have been working with for a number of years just how naive I was four or five years ago about the self storage industry.
I remember writing and saying, “With all the data and technology available today, there is no need for overbuilding of self storage. It is possible today to have a soft landing and not put more square feet in markets and trade areas already at equilibrium, thus causing oversupply.”
Boy, I sure was wrong about that.
I left out one important factor… the greed factor all humans tend to exhibit.
Funds
If it was just small investors who had to live with and on the cash flow of each project they do, perhaps the “soft landing” was a possibility, but doubtful.
I realize now I was attempting to beat the normal real estate cycle that has existed for a long, long time. I learned that in real estate 101, (1) expansion, (2) equilibrium, (3) overbuilding, and (4) contraction (or recession).
Theoretically, it could be possible with the data, especially for self storage, to not overbuild, market by market.
But again, no one factored in human greed, especially regarding funds.
So, if you are a small investor, think about your problem today.
Your issue is you are having a hard time finding deals that work. Right?
Now imagine you have, let’s say, $20 million, $50 million, or $100 million dollars you have to invest because you owe money on it now to the investors who gave it to you. It has to get out the door into self storage deals fast.
You or someone in your organization has a powerful and well-thought-out financial model that shows a good return to investors using a combination of good management and marketing skills, a low cost of financing money through a hot shot financial instrument, and low operating cost through creating a larger footprint, etc.
But that is on paper or a computer. You can’t find many deals or enough deals to get that much money out the door, so you build.
And build.
Now, if you are a fund, you are going to make money:
- When you get the initial investment dollar in.
- When the money is deployed into a deal.
- When you put a loan on the deal.
- Yearly for “managing” the money, and so on.
Some combination of fees pays you. Now that is before the deal spends any cash.
Finally, when the investor starts getting their return on investment, you will get some cash flow, and after the sale or disposition of the deal, you get a lot.
I am not saying anything is wrong with funds, even big funds. I am saying they are very incentivized to do transactions.
It is a transaction-driven model.
And they are good at doing lots of transactions.
So, if prices are too high (due largely to their activity), and you have to do transactions, what do you do?
You build.
And you don’t build small.
You build big. Big multi-story, thousands of square feet at once because it can move large qualities of the money out the door into deals.
Every fund’s financial modeling is different, but they all probably have some things in common.
Low-cost money for the “loan” portion of the deal. Low operating cost due to “scale.” An ability to lease up fast using state-of-the-art “online marketing” or a REIT to manage who has that capability.
Now I don’t have definitive data on funds. There is some data, but not easy to find unless you subscribe to an investment data site.
I sneakingly suspect that there are currently “great returns in the fund world.”
However, like the mutual fund world, in most years, only about 3% of the mutual funds outperform the S & P and Nasdaq index funds. And rarely are the same 3% funds outperforming the index year after year.
I am betting that a small percent of the funds are lifting the returns for all “self storage funds.”
My experience is the people in the funds who do the financial modeling are trying to figure it out just like we are in the real world.
Higher Interest Rates
Now, this all leads up to this.
I bet for many of the financial modules out there, the increased cost of the debt portion of the financial modeling could really throw a wrench in it.
I think increased construction costs already have. Add this double whammy with higher interest rates, and I bet it will really mess up a lot of modeling.
How can we tell?
Well, immediately, I think we will see a lot of large, new construction deals hit the market that have already been approved but perhaps now no longer work in the financial modeling due to the double whammy of increased construction cost and higher interest rates.
The funds have to make x% on the investment dollars, so, at least initially, the deals will be priced fairly high, so they can make enough profit on the “entitled deal” to pay their investors something.
Have you seen these hit the market?
I think it will be very interesting to see what happens in the next year or two as the real estate market slows down.
I bet many will add a 7% inflation factor or something to raise income to get the required returns.
Let’s see how long that can happen before investors, bankers, and appraisers catch on.
Perhaps as small investors who walk the other side of the street (cash flow rather than transactions) can start finding some real market-driven deals again.
Now don’t get me wrong, I like funds and REITs.
They have come to play an important part in our business strategy.
Every deal we have sold except one was sold to either a REIT or a fund.
I don’t want to see them disappear.
Perhaps just less transaction-driven and more in the world of reality (except when buying my deals).
I just am looking forward to a leveling out on the playing field that gives us small investors, who are living in a world of real returns and not transactions, a fighting chance.
I am also looking forward to seeing how their financial modeling changes to meet the new market emerging in the self storage space.
Change is good. It creates opportunities for those who can quickly adapt.
