Last week I told you I love self storage conversions.
I also love self storage expansions.
Like conversions, we have made a lot of money for my family, partners, and investors.
I have also seen many people I coach and train do well with expansions.
But I have seen and made some mistakes underwriting expansions.
Especially today, as I write this toward the end of 2022 and the start of 2023, I am seeing what I think are mistakes being made as I review underwriting people are doing.
I am not a fortune teller, and I can’t look at a Proforma and say this is exactly where you are wrong.
A proforma is an educated projection of future financial events in regard to the storage opportunity (the optimal word is educated). There are a lot of unknown variables, like the recent interest rate hike, recession or potential recession, etc.
Given some experience over the years, let me share with you the mistakes I have made in the past and what I am seeing today that I think may be problematic.
Again, I am not saying I am right about everything. I am just telling you what we are currently doing and what I would recommend today in underwriting a self storage expansion.
Expansions
Let’s start by being clear about what an expansion is in regard to this episode.
What I am calling an expansion is when one purchases an existing self storage facility, usually already in operation, and then adds more square feet of new storage on excess land or on land adjacent to the existing facility.
Mistake One: Too Aggressive Rental Income For Expansion
No one, especially me, knows what the future holds.
Because we are facing (1) a potential, and in some areas of the US, an existing recession, and (2) because of the amount of current supply on the market and rush of capital to the self storage space, we are underwriting the new space 10% to 20% below current rates.
I know this is hard to make yourself do.
If you are currently getting $15.00 per square foot for existing climate-controlled space and adding a climate-controlled expansion, it is difficult to underwrite the new space at, let’s say, $13.50.
But that is what I am doing.
At the very least, reduce the income by 10% to 20% during the lease-up period for rental concessions.
I have seen markets where rents dropped by 30% because of supply issues.
This is rare, but I have seen it.
Also, because the Fed will feel like it has done its inflation reduction job when the economy officially goes into recession, this could also impact rents.
If your project works on paper at a reduced rent and that reduction never happens, you are just that much ahead.
But believe me. It is not fun coming in under your estimated income projections, especially if you have investors.
Today, we are reducing future rental income in our projections. You could also stress test a project with lower rent and see if that would bust the deal.
If it does, as a general rule, we are passing.
Mistake Two: Too Aggressive A Lease Up Period
In The Storage World Analyzer, in the assumptions tab for expansions, there is a line item called “absorption.”
That means how many square feet per month will the new space rent up per month once leasing commences.
It is a square foot number.
However, in most markets, what I am seeing today is between 3% to 5% or 6% of the new square feet being absorbed per month.
I will calculate the “absorption” number using that formula today, then convert to a square foot number.
For example, if I have a 30,000 square foot expansion, and the market is doing OK but not extremely undersupplied, I may use a 4% per month number, which translates into 1,200 square feet per month net absorbtion.
Ultimately, your feasibility report will give you a number or a range, but in the preliminary proformas, this is how we run them.
I have leased up faster, much faster in some cases, but this “realistic” approach usually covers most of us and is a match for what often happens in reality.
I have worked with people who feel they can translate the lease up success they have had in other sectors to self storage. I have heard things like “…we use call centers to prospect for customers.”
I have also heard” …our management company says they can lease up in six months.”
All that is well and good and perhaps you or they can, but underwrite to cover your tail.
I have had absorption be as low as 830 square feet per month over a two-year period.
Not fun.
Our economy and many factors that are beyond our control have an impact on absorption. I recommend not being too overly optimistic in this assumption.
Again, if the project works at 1,200 square feet per month, it will be great at 2,000.
Mistake Three: Construction Time
Today, construction just takes longer than it did a few years ago.
If we are underwriting an expansion today, I just assume it will take a year to start generating income in the new space.
I have seen six or seven months in recent proformas.
If it is parking, perhaps, but for any self storage expansion today, just assume it is going to take at least a year to start getting income off the new space.
It may be even longer if you are in a heavily regulated area.
If you are rezoning land, assume it is going to be even longer than a year.
Yes, you may be generating income earlier than one year, but don’t make the deal need that to work.
Too much is out of your control.
Conclusion
These adjustments we discussed in this episode reduce the number of projects that financially work, but that is better than the alternative.
As the economic landscape changes and I begin to adjust our underwriting on expansions substantially, I will let you know.
But for now, these are the three mistakes I have made the most, and I am currently seeing that had me write this episode.
But do expansions. They are a great way to get in or grow your self storage business.
