Perhaps one of the best advantages of self-storage is the very few ongoing capital expenditures that are required.
It is one of the main reasons I was initially attracted to this asset class.
As a property manager and commercial broker, I saw how capital costs decimated the distributable cash flow from an otherwise good net operating income (NOI) on some of the properties we managed.
Commissions, tenant improvements, new carpet, painting apartment units—you get the picture.
There were years when I had clients with great NOI lines for a given year, but after the capital costs, they had little or no cash left.
Especially in the office buildings we managed.
Then, I discovered self-storage. I really fell in love with the steel wall and concrete floor units generating apartment-type rents with their very limited ongoing capital requirements.
Notice I said very limited. There are some, however.
How does a small investor plan for them?
As someone who put partnerships together and raised money to do my deals, I never wanted to take monthly operating profit to pay for capital items.
Let me share with you how I recommend accomplishing that task.
What Are Capital Expenditures?
Before we get too deep in the weeds, let’s discuss what a capital expenditure is.
In short, as self-storage owners, we are buying capital items (the buildings, the mechanicals, the doors, etc.) to generate operating income.
When we measure cash-on-cash returns, for example, we measure the operating income profits on the amount of cash we have in the deal.
There are basically three types of income one could have in an income-producing asset: (1) operating income, (2) loan proceed income, and (3) sale of capital items.
Mostly, when we refer to profitability and returns yearly, we are referring to operating income profit.
Anything that cuts into the NOI reduces the value of our asset and decreases the distributable cash flow.
The NOI is calculated by operating income (i.e., rent, retail sales, etc.) less operating expenses (property taxes, utilities, insurance, property management, advertising, etc.). This is the cost of operating that facility.
Loan costs are not included as an operating expense. You could buy the property all cash or 100% debt. Either way, the operating expenses would not change.
The other things not included as operating expenses are capital expenses. Expenses that enhance and maintain the capital items (i.e., building, doors, pavement, etc.) going.
One quick way that used to work before many items were allowed to be depreciated in year one was to distinguish the difference between a normal repair cost and something that could be depreciated over time for tax purposes.
For example, a new roof is usually depreciated over the standard depreciation schedule for commercial properties.
Fixing a door latch isn’t.
Resurfacing the asphalt is usually depreciated over time; repairing isn’t.
A new furnace is a capital expense, repairing one is an operating expense.
If there is ever a question, ask your CPA whether a particular expenditure is a capital expenditure or an operating expense. I did in the early days of my self-storage career.
My goal was to have a reserve fund set aside so that any time I had a capital expenditure, there was cash available and I didn’t have to dip into normal monthly operational profits to pay for it.
The good news is that this is self-storage, and the reserve funds required are rather modest compared to every other asset class.
The Reserve Fund
Establishing an appropriate reserve fund is not rocket science, but it does take a little work.
What I do if I am buying an existing self-storage facility is to have someone during the physical inspections give me a report on the mechanicals, roof and structure, asphalt or concrete condition, etc. (all the capital items).
Then, if it looks like I am going to go through with the deal, I take each aspect of that report and figure out when and how much replacement of these capital items is going to be.
If an air handler is estimated to last five more years, I know then I need to have x dollars ready to replace it in five years. I do that with all the items in the report.
I project out ten years or so, have a capital budget in place, and then figure out what I need to set aside yearly from operations each month or quarter before profit distributions. I make it the same amount every month.
It is usually between $600 and $1,200 per month, depending on the size of the facility. This usually equates to between 13 cents per square foot per year and 18 cents per square foot per year.
Tell me, what other asset class can you set aside that little reserve and be in good shape?
If it is a new build, I go through the same exercise with the general contractor and come up with a budget.
If you ever put a CMBS loan or an insurance loan on a project, they are going to do this and manage your reserve fund for you. For the last CMBS loan, we had required 13 cents per square foot per year for a reserve fund. I would fund it monthly, and when I had a capital expenditure I had to pay out, the lender would reimburse us from that account.
This also frees us up to have a high deductible for our property insurance, keeping our insurance costs as low as possible. I usually try to set the deductible at $10,000 per claim.
When we have made an insurance claim, it has always been to replace or repair a capital item. I pay the deductible out of the capital fund.
We had a $60,000 sign blow down in a wind event once, and the day we paid the sign company for the replacement, we did not miss a cent in that month’s distributions. I paid the $10,000 deductible out of the reserve fund, and the insurance covered the rest.
We usually start the reserve fund at closing with one year’s reserve in place if we can.
Then, for the most part, we just sit back and watch it grow because there are very few capital expenditures, as you know.
I hope this helps. In my experience, the key to not having to interrupt your cash flow distributions is to have a modest reserve fund in place to handle the few schedulable and rare surprise capital expenditures that may arise during your holding period.
If you are raising funds to close on a self-storage project, be sure to tell your potential investors that no other asset class offers the possibility of such steady and predictable cash flow as self-storage.
Now you know one of the main secrets to fulfilling that promise.
