I discussed in last weeks’ episode How To Analyze An Expansion self-storage opportunity. This week, lets look at a conversion.
When we say conversion, what I mean is we take an existing vacant building and convert it to self-storage.
In my opinion, in today’s market, this is one way to reduce risk and a good way to get into the business.
However, if you have an empty building, how can you know if it is a good opportunity for self storage?
Well, you have to run a financial analysis.
Let’s look at one.
The Building
Let’s take a sample listing I see in a tier 2 market in the Florida panhandle. This is a market where REITs are, so for us, it is a market we can focus on (i.e. part of our business strategy).
Given it is an active listing, and I don’t have permission from the listing agents to use publically, I will not show it here. But here are the vital stats.
- 45,871 sq. ft.
- Mostly warehouse over 17 feet clear height
- 2,600 sq. ft. office single story
- Although the industrial building, metal exterior, located with good visibility and one block off the expressway.
- On edge of the Central Business District.
- Listed for $1,400,000
- $30.52 psf
Like last week, the first thing we do is what we do for every opportunity, we examining the submarket. I use Yardi Matrix for a quick look into the market if they have the data. I know this is not exact, but it lets me know if I am wasting my time in an overbuilt market. Ultimately I will get a feasibility report indicating the supply/demand, as well as a barrier to entry information, unit mix, and another Performa, but here I just attempt to see if it is overbuilt.
Yes, I know Yardi is expensive and most people can’t afford it (I’m not sure I can), but I have to use something. In the old days, I would Google and attempt to estimate the amount of self-storage and use the demographics in the marketing package, or what I could find online to try to see the number of square feet of self-storage per person in a submarket.
Depending on where it is, I usually like to see 7 or 8 square feet or less per person. The more space I am bringing on, the lower I like to see the number. In dense markets like Miami, FL, a higher number is OK. In smaller markets like this one, I want a lower number.
We will get a feasibility report to verify and go deeper than I can here. I just don’t want to waste my time in a market that is clearly overbuilt.
For this project, I am thinking there is some unmet demand. There were about 6 square feet per capita in 3 and 5-mile radius. My competition is all very full and there was no discounting going on. I had a hard time finding a 10 x 10 in this market.
Overview
Before we dive into the detail this opportunity, let’s take a quick overview again.
Our goal is to purchase capital items, in this case, an empty building and a self-storage system, and generate ongoing cash flow and increased value.
The goal we strive for is for our income to go up at a faster rate than our operating expenses. In other words, each year of the ownership hold, we strive for an average of a 3% rental increase and try to keep our operating expense growth closer to 2.5%.
3% is not hard to average. Even in recessionary times, over time, 3% is fairly easy to maintain. From 2008 through 2012, we may not have had a 3% price increase each and every year, but by the end of the recession, we averaged 3%.
2.5% has been the average inflation rate over the last decade, so that seems like a good number to use for operating expense increases.
If you do that year after year, the gap between rental increases and operating expense (in this case .5%) will compound and can create some real wealth.
So analyzing is great, but remember, after you put a project in service, your job is to know where you are in terms of income year by year and expens4s year by year. Usually my income and expenses will be somewhat different from what I may have projected, but it is amazing how close the NOI can be, and that is the number because the value of your self-storage project is determined by what a ready and willing buyer will pay for the NOI (net operating income i.e. income less operating expenses) cash flow.
Conversion Analysis
So let’s look at what we can do with this building on a conversion.
The building is 45,871 sq. ft. My experience is in conversions, we usually get between 70% and a 73% efficiency. In other words, of the 45,871 sq. ft. let’s say 73% will generate income. The rest is hallways restroom etc. And remember, in this building, there is a 2,600 single floor “office area”. It is front and center, so it will be the entryway for the new traffic. We will make that the office area, retail area and perhaps have some units to show different sizes. It is more than we need for an office/retail area. Today, we try to keep the office/retail to about 1,200 sq. ft.
So we have 43, 271 sq. ft. of 17 clear height warehouse. We need at least 16 feet 8 inches’ clear height to get two stories and this building will allow us that.
So here is the math:
- 43,271 x .73 = 31,588
- 31,588 x 2 = 63,176
So for preliminary analysis, I think we will be able to get up to 63,176 sq. ft. of income-producing self-storage sq. ft. in this building.
Again, I am assuming here that there is enough demand for it. Our feasibility report will ultimately inform us if this is true.
Step Two
Next, I want to get a feel for what the rental rates are and how much I can get per square foot for self-storage in this market.
I can go to the websites of the other facilities in this submarket and/or use Yardi. I did both and determined that $13.45 sq. ft. per year is what we can expect on average for climate controlled space in this submarket. Remember, this will be a climate controlled space because it is in an existing building.
So let’s get started analyzing. I will also use the Storage World Analyzer for the analysis. I could use excel, and do for some projects, but usually, I start with this program. You don’t have to use it and can use excel, but I find it easier and faster as well as more accurate in most cases. Also note, I sell it (click here if you are interested), but I want to be very clear, you can be successful using excel, I just love this program and hope people who use it find it as user-friendly as I intended it to be.
So let’s create a conversion. To do so use the “New Construction” tab.
Next, lets put in the size and income. Since we don’t have a unit mix yet, let’s just use the “Specify By Square Footage”.
Enter the sq. ft. you are going to have to produce rent and the average expected rental rate. I also will have an office/retail area, so I expect about $350 per month in retail sales.
Step Three
Next, I attempt to come up with an estimated construction budget. Again, this is a preliminary budget, so instead of filling out a complete budget (which I will do later if the deal looks good), I just use a per square foot number.
Given this is a conversion, the number could vary a lot depending on what I do with the building. I want to create openings in the existing building that will showcase the doors, demo the office and create a new retail area. Etc.
If you have no idea about construction, the Storage Almanac and other data from the SSA or Mini-Co or the ISS (Inside Self Storage) can help with average numbers.
After reviewing what I plan to do with this building, and the cost of the system (I am using $14 psf in today’s steel tariff environment) I am going to use $37 psf. Some will spend less, some will spend more. I think this allows us to do what we want to do and create a good product without going over the top.
In this number I have a new office, the system, new HVAC and upgraded electric and HVAC. I have also allocated a good number to convert the outside with glass openings that showcase the doors inside.
If this deal looks good, I will fill out, or have someone fill out a full construction budget, but for now, let’s use a per sq. ft. estimate.
Step Four
The building is listed for $1.4 million. Let’s assume I can get it for $1.265,000. I put that in and between feasibility and preliminary inspection and approval cost, let’s use $20,000 due diligence.
I could use a lot of different type of loans, but today I will assume a regular local banknote. 20-year amortization, 5.5% interest and a 75% Loan To Value. Because this is going to be a partial construction loan, I will be able to get 2 years of interest only most likely.
Step Five
Now I enter the project assumptions. This is what makes a big difference in how we analysis deals over just doing a snapshot of a deal when it is stabilized. I am assuming that my income rises 3% per year, that my operating expenses go up 2.5%. Depending on the type of facility, I usually today use a 7% CAP rate for future values. In other words, every year I will determine the value of the project by applying a 7% CAP rate to the NOI (net operating income) for that year. The Storage World Analyzer does this each year in the ten-year cash flow statement.
I also assume my cost of sale is 2% or 3%. It can be higher if you list the property, but we have been selling direct to the REIT when we sell.
Then I put in stabilized occupancy. In other words, how will I run this project and what will my economic occupancy be. This program will apply whatever I put in here to the GPI (gross potential income).
I am going to use 85% stabilized occupancy. Now I know many facilities are well over that now, but I always use 85% or a maximum of 88%. This is the historic average, and most lenders are going to underwrite in the ’80s, not the ’90s.
Here is where I mark up the building to the actual gross size. Remember, I used a 73% efficiency factor for net income producing square feet.
Because this is a conversion, we can start getting income much faster than if this was new construction. I am going to assume it is 7 months of approval and construction time before we can start generating income. I have been able ion some conversions to get this even quicker, but let’s use this,
I am not sure how fast this will lease up either. Given the apparent low square feet of self-storage per capita in this submarket, I am going to assume about 1,500 net square feet per month will be rented during the lease-up phase. Ultimately the feasibility report will inform us what to expect.
Step Six
To complete the conversion project analysis, we need to fill in the anticipated operating expenses. Now I can hear many of you saying,” I don’t know what they will be”. Well, let’s make an educated guess. Figure out how you are going to run it.
First of all, I think it will take about 2 full-time people. Now, during year one, it is not going to need that because much of that year is construction, and in year two, the early part of the lease up it may not need that. So I will reduce it in year one.
Also, I am putting in funds for a website and online marketing. I won’t spend it the first half of year one.
Next, I will put in about .13 cents psf for maintenance and some in for equipment, security, etc. I will reduce it some years one and two because it is the new and most associated cost will be included in the construction loan.
I am guessing insurance to be about $9,000 and I looked at the past owner’s utility bills and estimated an increase based on the type of HVAC we will out in.
I looked up the tax rate and guessed on the estimated taxes. Year one will be the current tax amount. Year two is when it will reflect the sales price and by year three it will go to the amount it should be for a self-storage project.
I am using a 6% management fee.
Finally, I put in all the numbers on incidentals we will need to run a self-storage facility. The banks and vise charges are mostly cost of credit cards. I have reduced the numbers years one and two top reflect an estimate on how we will spend as we bring the project into service and lease it up. All of these are estimates, but they are based on past experience.
If you feel you have no clue on management expenses, there is support material on industry averages at the Self Storage Association (SSA) and Inside Self Storage (ISS). Mini-Co also produces a yearly Storage Almanac that has a lot of good industry averages.
So now let’s take a look at what we have.
Here is a summary of what the project can look like with these assumptions.
So it looks like we break even in year three, about what I would expect. In the equity, we need about $300,000 for negative cash flow in years one and two on top of the 25%cash investment.
Here is the debt report.
Between the acquisition of the building and the construction, it looks like $3.6 million projects plus the negative cash flow. Let’s assume about $3.9 million projects.
Our break-even is in year three. It looks like we will be between 63% and 64% (the second screenshot below on the Lease Up Report) at the breakeven. That is normal, although I like it to be a little lower.
In year five it looks like the value of the facility is going to be approximately $6 million to $6.5 million (again, second screenshot on the ten-year cash flow statement). It looks like our cash-on-cash return after stabilization is 22% to 25%. Not bad, over 20% cash-on-cash and about $2.5 million of value created for taking the risk.
Conclusion
So is this a deal you would do? It depends on your goals and your business strategy.
For us, it can work. However, I would run it at lease-up with a lower rate to see the difference. I would also look at different loans and how that would impact the deal. What if I had to pay more for the building? What if I could get the construction cost down?
I run it a lot of different ways and then compare it to other deals I am considering. Ultimately, if we tie the property up, in our due diligence, we will replace our assumptions with real bid numbers and information from the feasibility report. If it still looks good, we move forward. If not, we go to the next deal.
I hope this helps as you are getting or grow your self-storage business. No matter what is happening in the market, we can always create deals that work. This is the best business there is for the small investor.
There is a risk as you can see. But look at the potential upside. The good news is that after the construction number is in and the lease up to stabilization occurs, there will be much fewer capital improvements to deal with than any other type of investment commercial real estate.
Good luck and keep us posted as to your progress.
