By Ben Vestal

any of you have seen the latest reports on increasing inflation in today’s economy. Inflation is the scourge of savers, diminishing the value of nest eggs and retirement accounts. Among other things, inflation is the result of a “cheap money” policy (very low interest rates), and after decades of low interest rates and four years after a $1.9 trillion COVID stimulus bill, inflation is proving to be more stubborn than we all anticipated. Whatever the causes of inflation, the results are devastating for most Americans, and we are starting to see the trickle-down effects in self-storage. The last time the U.S. Men’s hockey team won Olympic gold (1980), inflation was persistently high, interest rates were volatile, and real estate investors were operating in a fundamentally different market than today. With the U.S. Men’s hockey team winning gold earlier this year, are we on the verge of seeing history repeat itself?

But wait a minute; is self-storage inflation proof? Or should we say inflation resistant? Perhaps we are in good shape in our corner of the real estate business. Let’s spend a few minutes exploring self-storage as a hedge against inflation and analyze the positives and negatives to see how self-storage stacks up against other real estate investments.

The general way to protect your investments from inflation is to have your revenues increase along with the inflation rate and to have your expenses remain stable. At first glance, it might seem that this would be an achievable task within the self-storage industry. However, self-storage facilities have seen a falloff in revenue growth due to oversupply, consumer belt tightening, and a slow housing market. Meanwhile, operating expenses seem to be stabilizing but still growing due to inflationary pressures. The month-to-month business model that has always set the self-storage sector apart from other commercial real estate is being tested for the first time. We know from experience that small rental increases do not cause a mass exodus of tenants. However, the amount of oversupply, from a double development cycle (2014 to 2019 and 2021 to 2023) and the hangover from the aggressive COVID pricing models have put extreme pressure on self-storage fundamentals, causing most operators to experience negative roll down during these inflationary periods.

During inflationary times, value must come from income growth and not cap rate compression. Historically, during the late 1970s and early 1980s, income growth was strong and higher replacement costs pushed rents higher to justify new development when exit cap rates were elevated. While rising cap rates reduced the amount of value creation, they did not eliminate value creation altogether. What changed is how returns were generated. With value expansion no longer generated by compressed cap rates, income growth became the primary driver of long-term performance. Today the self-storage sector is working its way through the excess supply and whiplash from the COVID pricing models.

Controlling expenses is another matter, but self-storage starts off with a great advantage over many other real estate types because the gross margins (say 60 percent) are better, with expenses equaling only roughly one-third of the revenue. As a result, self-storage profits are higher and there are fewer expenses per dollar of revenue. When you look at the nature of self-storage expenses, you’ll find additional advantages. First, energy use is well below the average of most businesses, which has been a high-inflation expense item currently, with single-story properties with limited climate-control outpacing multistory projects built in the last several years. Secondly, real estate tax, typically the largest self-storage expense, only has a very rough correlation to inflation, and thus may not automatically adjust to inflation. In fact, with declining real estate values, you might even see your relative share of the taxes go down. Thirdly, self-storage labor is usually not as highly paid, as many of the workers under union contracts and in highly skilled professions that are closely linked to inflation. Not to mention, technology is improving quickly and will likely allow owners to limit office hours moving forward. While it is hard to precisely quantify these distinctions, they are real and will tend to mitigate the impact of inflation on the self-storage investment market.

After looking at the “cash flow” aspects of inflation, self-storage owners should feel that they are better off than most commercial real estate businesses when it comes to mitigating the impact of inflation. Simply stated, value in self-storage facilities is created by discounting the net operating income (NOI) at the prevailing market cap rate. If an owner can keep the revenues up and control the expenses, they will have protection on the NOI part of the equation, but inflation generally causes the cap rates to increase, which in turn discounts the value. While this is not a good thing from a value standpoint, it is also true that cap rates fluctuate dramatically over a period of years. Thus, if you have kept up with inflation and have some flexibility as to when you sell or refinance your property, you can preserve the value by waiting for a low cap rate or interest rate period. Beware: These real estate cycles always go further and last longer than anyone thinks. But the real advantage is that the loan amount you have to pay back was fixed on the day you took the loan out, so you get all the “benefits” of the value created by growth in the revenue!

What about other real estate as inflation hedges? The results are less dramatic because office buildings, industrial, and retail often have long-term leases that inadequately compensate for inflation. A little inflation that is not compensated for in the lease over a 10- or 15-year period will compound into a healthy diminution in the value of the cash flow and of the inflation-adjusted property. For example, a 5 percent increase in inflation that is uncompensated for in the lease for 10 years will decrease the value of the cash flow and capital value by 40 percent. Hotel revenues would seem to be protected from inflation, but their relatively high expense ratio tends to defeat a lot of the benefit of being able to set the rent every night.

All in all, self-storage, while not perfect at stopping inflation’s ravages, is certainly a lot better than other types of real estate and certainly better than bonds or the volatility in the greater equity markets. Because it isn’t my expertise, I will let you decide on the relative effectiveness of the stock market in beating inflation. We always make this inflation protection argument when we talk to buyers, and we find it is very effective in helping them choose a self-storage investment if they are looking for a stable long-term investment.