By Mark E. Battersby

By Mark E. Battersby

he self-storage industry’s high recession resistance and consistent cash flow are attracting the interest of private equity (PE) investors intent on acquiring fragmented, independent facilities. Could PE be the answer to the current economic situation of the self-storage industry?

Selling the self-storage business to, or being acquired by, a PE firm means transferring ownership in exchange for the capital needed for growth, advice, and support. Although PE firms usually maintain their ownership stakes in a business for only five to 10 years, during that period they work to improve the business.

Most PE firms serve as advisors to the businesses they’ve acquired, helping iron out inefficiencies, develop new leadership teams, launch new services, and find new avenues for the business to grow and profit.

Private equity is an umbrella term that can take many forms, usually depending on the targeted business’ situation. In general, PE encompasses:

• Leveraged Buyouts (LBOs) – Acquiring a controlling stake in a business using a significant amount of borrowed money (debt) and using the acquired operation’s cash flow to pay off that debt.
• Venture Capital – PE provides the funds and the support needed by early-stage, high-growth startups and small businesses that lack access to conventional capital sources.
• Distressed/Turnaround – In these situations, the PE firm buys underperforming or financially troubled businesses with the goal of restructuring their operations and returning them to profitability.
• Growth Equity – Probably the most common approach for a PE firm involves investing in mature businesses that need capital in order to expand, restructure, or enter new markets, usually without taking a full controlling interest in the targeted business.

For many self-storage owners, a PE sale provides an exit strategy and opens the door to thinking about succession planning. Acquisition by a PE firm reduces the operation’s dependence on the owner by bringing in new management. But is the potential for more tenants, increased revenue, or reduced expenses worth it?

Whether a sale occurs or an investment is made by a PE firm is a question that can only be answered with more questions, such as:

• What are the PE firm’s plans for the business?
• Is a sale the right path for the business and the owner’s exit strategy?
• How will the operation’s employees be treated?
• Will the acquired business continue to support the local community?

Regardless of the path chosen by a self-storage business owner, it is always necessary to determine the self-storage business’ market value. How does one obtain even an approximate value, a figure that is so critical to a potential transfer?

Valuing the self-storage business requires analyzing what it owns and how much revenue it generates. What is owned is fairly straightforward and includes capital assets, real estate, etc.—all offset by liabilities, of course.

A business is usually worth far more than the sum of its parts. There is, after all, the value of intangibles such as the customer base, the operation’s reputation for quality, customer service, and more that fall under the heading of “goodwill.”

Analyzing the operation’s cash-flow is often an effective valuation alternative. An operation’s revenue stream generally reveals many of those intangible assets such as goodwill. In fact, for most businesses, analyzing the revenue stream will have the greatest impact on its value.

Self-storage businesses typically value between $100 to $150 per rentable square foot or $1,000 to $3,000 per unit. Stabilized facilities trade at 12 times to 18 times EBITDA (earnings before interest, taxes, depreciation, and amortization), which is equivalent to 5.5 percent to 7.0 percent cap rates. Small or un-stabilized properties trade at 4 times to 8 times EBITDA (or five to eight times net operating income).

A cap rate (capitalization rate) is a metric that measures the expected annual return on an investment property. It is calculated by dividing a property’s net operating income (NOI) by its current market value or purchase price.

Every valuation can be impacted by the reliability of the reported revenue and the potential of growth over time. If earnings plateaued years ago, it might indicate limited growth potential or excessive competition in a saturated market. On the other hand, a steadily increasing revenue stream might indicate the prospect of even more growth resulting from increased investment.

Another option when valuing a self-storage business involves analyzing recent sales of comparable operations. Although this is an “evidence-based” value analysis, it is usually focused on specific factors and industry trends unrelated to the business. Interest rates and market volatility are often neglected variables.

A self-storage business owner dealing with a PE firm should be prepared to negotiate the structure of the potential deal and the terms and conditions. Negotiating the intangibles shouldn’t be overlooked.

Every PE transaction involves so-called “cultural aspects.” Negotiations here may often result in the business maintaining its identity and even its unique culture. However, there should always be a clear understanding of the desired goals and what is and isn’t on the negotiating table.

Financing, especially debt financing, plays a key role in every PE transaction. Usually, debt financing is a significant part of the transaction with leverage utilized because of the expectation that the improved performance of the self-storage business will ensure repayment of the debt.

After most sales, the atmosphere of smaller operations frequently morphs into a more corporate, profit-driven environment. The PE firm will often implement changes striving for more efficiency in the operation, greater growth, or perhaps to align the business with its current portfolio.

Fortunately, while the acquiring PE firm may influence the decision-making process, day-to-day operations are usually left in the hands of the existing management team in order to maintain the appearance of independence. Collaboration between both the PE firm and management is crucial during the transition period.

When it comes to taxes, the self-storage business’ owner and the PE firm buying the business need to agree on the structure of the sale. Both the operational implications and the tax situation of both parties must be considered.

PE firms are no different than most buyers in seeking greater depreciation write-offs. This usually means purchasing the operation’s assets rather than the self-storage business itself.

Sellers, on the other hand, usually prefer selling the business, or ownership shares, rather than the operation’s assets in order to reap better tax results. Fortunately, with negotiations, an agreement can be reached that satisfies the tax considerations of all concerned.

Operationally, the owner must consider how involved she is willing to remain. The buyer may offer an earn-out to the current owner for staying on for a period of time to ensure a smooth transition. After all, who’s better equipped to ensure that customers aren’t lost, employees remain, etc., than the current owner?

Obviously, with every sale, there are obstacles that must be overcome, some of which may actually be uncontrollable. A good example is when the seller does not want to continue his or her relationship with the business after the sale. Not only does it have a potential impact on the future success or failure of the business, but it also often affects the percentage of the sale price paid in cash.

The influx of institutional and private equity capital into the self-storage industry presents several notable downsides. Investments by PE firms in the self-storage industry have driven up the prices of facilities putting them out of the reach of independent buyers.

Private equity firms frequently implement so-called “dynamic pricing” algorithms (like those used by public REITs). While this can maximize short-term revenue, it often involves jacking up rental rates on existing tenants by 10 percent to 20 percent or more, leading to higher churn and damaging local community trust.

Plus, many PE firms rely on leveraged debt to acquire and upgrade portfolios. In a volatile rate environment, the debt service on these massive acquisitions can quickly cut into net operating income, triggering cash-flow issues.

Private equity firms typically have a medium-term investment horizon, often aiming to exit within a certain timeframe, such as five to 10 years. Their goal is to maximize the value of the investment during this period, which may involve implementing operational improvements and then selling the business for a profit.

While the financial benefits are appealing, and the hurdles usually negotiable, is the promise of an improved operation with greater profit potential worth a private equity deal?