I speak often about the oversupply of self storage in certain markets and how to position yourself to stay relevant in today’s market.
My default setting is to assume that everyone has a real estate background and understands where we are in the current real estate cycle. I realize I shouldn’t do that.
Let’s back up a minute and make sure we understand the different phases of the real estate cycle and where we are currently in this context.
In this episode, I want to look at textbook real estate economics so you can get a clear picture of the never-ending real estate cycle.
No matter where you are located geographically, there is opportunity in self storage. The game is to have a realistic understanding of your market and what’s coming next so you can adjust your activities to take advantage of it.
The Real Estate Cycle
The classical real estate cycle has four phases. As I look back over my career, I have seen five of these cycles. I entered the workforce when we were in a recession and interest rates were pushing 16% to 18% (and we complain about 5% and over).
I remember when I was selling real estate and interest rates went from 12% to 10% and I said I could sell real estate all day long if interest rates stayed there.
But back to the subject at hand.
The four phases of real estate are:
- Recovery
- Expansion
- Hyper Supply
- Recession
Every real estate cycle has these four phases. There is what economist call “lag” in the cycle because the development phase takes time.
The point where “Expansion” becomes “Hyper Supply” isn’t always clear, but because of the “lag” involved, we can usually see it coming.
What I find really interesting about self storage is this cycle is a local phenomenon.
We talk often about the national picture of the self storage industry. The news and magazines speak about it as if it’s a national or global situation. But that only happens when enough local markets experience the same thing and collectively enter a particular phase.
Self storage is local to the extreme. This allows us to successfully develop in one part of a market that is undersupplied while avoiding parts of the same market that are oversupplied. These markets can be cities or regions of a state or country.
Let’s take a look at each of the phases of a real estate cycle:
Recovery Phase
Before this phase starts, there is oversupply from previous cycles that have been absorbed. That oversupply usually creates negative demand growth or higher vacancy rates.
“Recovery” begins when the excess supply is finally absorbed.
I remember back in 2009/2010 when the financial news was broadcasting that “Recovery” had started, but it sure didn’t feel like it where I was located.
Office product in our market in the Class B was still over 20% vacant and retail was not far behind.
In 2009 I had just gotten back into the industry and only had one facility. We were at 83% occupancy. We had a 6% dip at that facility. Little did I know that it was going to be close to the average for the nation in self storage for this recession.
In the “Recovery” phase, space is slowly absorbed and rental rates begin to increase.
The Federal Reserve usually tries to help by reducing interest rates to stimulate the economy. Owners and Landlords are slow to act because they are experiencing the slow absorption rates (leasing up their space) in the market.
In my hometown, we opened my second facility in 2010 – an existing building conversion. For over three years it was the only new self storage facility in our market. People thought we were brave, but we saw the negative supply in this submarket and interest rates were low. We also did a mixed-use project to have some income during the lease up, so we had money in place from day one to service the debt.
Eventually in “Recovery,” the market reaches its long-term average occupancy rate. For self storage, this is approximately 85% (depending on the location and size of the facility).
Expansion Phase
In this phase demand increases.
In the last cycle for self storage, it began in late 2012 and early 2013 in earnest. That is when the REITs and other buyers started their buying spree that raised the prices and started reducing CAP rates for self storage.
The last stabilized facility I was able to buy and put into service with good returns was closed on in late December 2012. After that, everything we have bought has had to be a value-add situation in order to generate the returns that we need.
Historically expansions are slow uphill climbs.
That is what happened in our industry. Prices were high and rental rates were going up over 6% a year for us. But it was really not until 2015/2016 that we started seeing a lot of new construction.
Technically in this party of the cycle, there is a magic point where demand and supply meet. That point is called “equilibrium.”
I can remember writing about being there and cautioning about starting the oversupply phase of the cycle.
Now the information is easily available for all of us to know when a submarket is in equilibrium. There is no longer any need to start the over-supply phase of the cycle. But never hitting that phase is a pipedream. Someday we humans could be smart enough to use the data and hang out in equilibrium longer. But we’re not there yet.
It can be hard to tell when the cycle starts to slip into the next phase because there does need to be some new construction to fill the demand that the “Recovery Phase” generates. At some point, the new construction outpaces the demand generated by “Recovery” and we begin the next phase of the real estate cycle.
Hyper Supply Phase
For many self storage markets, we have been in this phase of the cycle since late 2016 or early 2017.
This happens when new product is being developed while occupancy falls.
Oversupply.
Hyper supply.
Eventually, developers recognize the oversupply and development ceases (theoretically).
What is so frustrating is that in theory, we don’t have to get here. The tools and data to determine the supply demand for most submarkets are readily available. Since self storage is so submarket oriented, this data is very accurate.
But I guess people don’t want to miss out on something and decide to go for it anyway. Or they don’t do their homework.
Don’t be one of those people.
Because of the “lag” of construction time, as new product hits the market, occupancy rates are falling and then you hit the next phase.
Recession Phase
In this phase, there is oversupply, demand is falling, rents are going down, and losses occur.
Usually, because of hyper construction, interest rates have risen. That begins to slow down construction but it also has a negative effect on owners. During this period of higher interest rates and dropping occupancy rates many projects loose value and negative cash flow can happen.
Again, during the recessionary periods, self storage tends to perform better than most real estate products because most of the customers are people that are in transition. Recessions cause transitions and spur demand for the product. But there is less disposable income in the economy so owners have to work harder to collect rents due and the economic occupancy to physical occupancy increases.
The Good News
Here is the good news. No matter which cycle the market is in, there is opportunity.
Most of the fortune 500 companies today started when the market was in recession.
One part of the cycle is not better than the next.
You do different things as an owner and as a buyer, depending on where you are in the cycle.
Don’t be afraid of any part of the cycle, be prepared. By knowing where you are and what is coming next, you can thrive.
How does that look on the court?
If you are looking at a facility that is 93% occupied and you are doing an analysis, underwrite it at 85%.
If your rents have been going up 6% per year, project them as flat for a couple of years and 3% after that.
If market rents are $14 psf, and we are where we are in the cycle (Hyper Supply for most markets), underwrite the project at $12.75 psf income.
Know the per square foot per capita of a submarket you are looking at as well as what is in the pipeline to go into operation soon.
Don’t spend all of your money now. In the recession, lots of product will hit the market because loans are coming due and people who overpaid can’t renew their loans.
Success does not happen without knowledge and planning.
This product did very well and got everyone’s attention in the last recession. So be prepared and don’t be afraid of any particular phase of the cycle.
This real estate cycle was happening before us and will continue after us. Be ready to take action and know what is coming next. You will then thrive and create True Wealth in this fantastic business of self storage.
