ome industry experts say that self-storage investors are lowering their expectations for returns amid the continuing tough economic environment.
But self-storage is still positioned as the strongest class of real estate compared to the traditionally main types (multifamily, office, industrial, retail, and hospitality).
Steve Mellon, senior managing director of Houston-based JLL Capital Markets, says requirements for investor returns have risen because of rising interest rates, which cause the cost of capital to increase.
“We have seen the cost increase not only for the private capital buyers [mom-and-pop operations], but even the national REITs’ cost of capital increased substantially over the last 12 months,” Mellon says.
Amid several interest rate increases in the past year and a half, the Federal Reserve System’s Federal Open Market Committee (FOMC) said on Sept. 20 that it would hold the federal funds interest rate steady at 5.25 percent to 5.5 percent. The federal funds rate is the overnight interest rate commercial banks charge one another to borrow or lend extra reserves. The federal funds rate also can affect short-term credit card and consumer loan rates.
The FOMC also says it still aims to reach maximum employment and a 2 percent inflation rate in the longer run.
“Recent indicators suggest that economic activity has been expanding at a solid pace,” the FOMC statement said. “Job gains have slowed in recent months but remain strong, and the unemployment rate has remained low. Inflation remains elevated. The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.”
Investors are also lowering their return expectations, but even lessened returns exceed other real estate classes, he says.
“It’s a pretty bleak story for all of commercial real estate because of rising interest rates,” Mellon says. “But bad news for storage is a lot better than for retail and hotels. We’re cooling to 3 percent [rent increase rates] from 10 to 15 percent. But retail and office guys say, ‘You mean you’re still growing? We’re going backwards 40 percent.’ This will just be another time that storage will prove to be recession resistant. Storage will show why it’s a great asset class during a recession.”
Self-storage as a class of real estate is relatively new, Mellon says. It “really took off” in the 1990s and became a relevant real estate sector. The financial carnage in 2008 and the onset of the COVID-19 pandemic both tested the self-storage sector among all others. But self-storage had the second-lowest foreclosure rate in 2008 behind mobile home manufacturing, and it performed well during the onset and worst of the pandemic.
Because of uncertainty about future interest rates, JLL expects investors to focus more on assumptions about future rental rates that they can come closer to proving today rather than in the future, he says. But he adds he’s optimistic that the construction slowdown will help self-storage in the long term. Most owners will say the one thing that affects their stores the most “is a competitor opening down the street.” This generally should help existing properties’ future cash flows.
The recent acquisitions by Extra Space of Life Storage and by Public Storage of Simply Self Storage—transactions valued at roughly $15 billion combined—“have propelled the self- storage sector to the lead in 2023 deal-making as of July 31,” Chilton says.
“After record-level fundamentals in both 2021 and 2022, a return to normalcy seems evident thus far into 2023. … Record low mortgage rates early in the pandemic brought elevated home sale activity and moves away from coastal urban cities,” Chilton says. “Furthermore, work-from-home resulted in scores of households suddenly looking to cram office space into their homes.”
Though decreasing demand is lowering move-in rates, some factors can counteract that, Chilton says:
- Supply “looks to be manageable” over the next few years.
- ECRIs seem “to become key drivers to revenue growth, supplanting declining move-in rates.”
- Higher mortgage rates decrease the ability to move into bigger spaces, and remote or hybrid work has caused “stickier customers leading to record-high customer length of stay.”
Chris Sonne says rising interest rates drove a 21-basis point increase to 5.56 percent in the second quarter of 2023, based on Newmark Valuation’s investor survey. Sonne is Newmark’s executive vice president and specialty practice co-leader for self-storage in the company’s Irvine, Calif., office. The second-quarter increase represents a 34-basis point increase since the fourth quarter of 2022.
Self-storage capitalization rates (typically calculated as net operating income divided by current market value) and returns have increased with the 11 interest rate increases since March 2022, Sonne says. But self-storage cap rates “are not rising commensurately at all” partly because of the strength of the asset class.
The asset class remains strong, but self-storage transaction volume has decreased by 70 percent, he says. And almost 70 percent of the transactions were for less than $5 million. He calls that “kind of interesting for single assets.”
But self-storage also has had the biggest portfolio transaction volume this year in the sector’s history, over $18 billion, Sonne says. He cites the Extra Space and Public Storage transactions as the main drivers of that dollar figure, “and then there’s a bunch that are under $1 billion.”
“What’s interesting to me is it tells me the institutional money is bullish about self-storage over the long run, and that’s always been storage,” says Sonne.
“It’s a long-run game. This year has not been the best year in terms of operations, with lower rent increases and occupancy down a little bit. But I just say it’s a reversion to the mean. Things are just sort of returning to normal for self-storage. It’s just that we had a couple of phenomenal years there during the pandemic. That mean is very strong.”
Looking back 25 years at the commercial real estate return numbers, self-storage is king. Sonne compiled National Association of Real Estate Investment Trusts (NAREIT) data on investment returns from 1994 through 2018. Self-storage had average returns of 16.7 percent for that 25-year period, the NAREIT data shows. This compares to 12.9 percent for apartments, 12 percent for retail, 12.7 percent for industrial, and 12.1 percent for office.
“It makes sense that when you see people looking for safety in certain markets they go to self-storage,” Sonne says.
Self-storage investors continue to expect strong returns, Sonne adds. Their expectations keep rising because interest rates are rising. When interest rates rise, cap rates and returns follow suit, “even if you’re buying all cash.” That applies to all commercial real estate segments.
Sonne thinks that self-storage returns will stay “relatively flat” in 2024 and that the Fed “is just about done in raising interest rates.” He recently spoke to two investor groups. He always asks audiences what their expectations are for rate increases. About two-thirds of those he spoke to think there is probably one more 25-basis point increase by the Fed coming by the end of 2023.
“Inflation is so stubborn—the term is “pernicious”—and I think the Fed is pretty determined to battle it with interest rates as kind of the only lever they have left,” says Sonne. “What I hear from a lot of people is, ‘Stay alive until ’25’ in other sectors. Storage isn’t so bad. But office sectors and things, when they have money coming due, they’re just in a world of pain.”