It’s undeniable: Americans have an addiction to self-storage units. Driving down highways, through cities, or along country roads, an incredible number of these facilities exist. As an investment opportunity, they offer significant upside. But, many new real estate investors don’t have experience analyzing these deals. As a result, we’ll use this article to explain self-storage property underwriting.
Specifically, we’ll cover the following step-by-step guide for how to underwrite a potential self-storage deal:
- An Overview of Self-Storage Investing
- Self-Storage Underwriting Step 1: Confirm Unit Rents
- Self-Storage Underwriting Step 2: Confirm Operating Expenses
- Self-Storage Underwriting Step 3: Determine Property Value
- Self-Storage Underwriting Step 4: Back into Permanent Financing Availability
- Self-Storage Underwriting Step 5: Confirm Acquisition/Rehab Budget and Financing
- Self-Storage Underwriting Step 6: Project Cash Flows and Assess Investment Criteria
- Final Thoughts
An Overview of Self-Storage Investing
Self-storage investing offers investors significant up-side potential. In addition to solid cash flows, these assets tend to perform counter-cyclically, making them an outstanding hedge in a property portfolio.
With many commercial real estate types, performance correlates with the economy. That is, in good times, the properties perform well. Conversely, in economic downturns, they perform poorly. Self-storage units typically behave differently. When the economy contracts, two events tend to happen:
- People downsize into smaller homes or apartments.
- People go back to school.
In both of the above situations, people need to find places to store excess belongings. Neither small homes nor college dorms or apartments have a ton of space. And, rather than sell or throw away stuff, we have a natural tendency to hold onto things when we downsize. This reality leads people to rent storage units. As such, when the economy contracts, self-storage demand – and property performance – often increases.
This hedging phenomenon makes self-storage units appealing for many commercial real estate investors. In the rest of the article, we’ll explain how to underwrite potential self-storage deals to see if a particular property makes sense for your portfolio. In particular, the below steps assume investors look to A) purchase a self-storage facility with short-term financing; B) make value-adding improvements; and C) refinance the property into a long-term mortgage.
Self-Storage Underwriting Step 1: Confirm Unit Rents
To underwrite a self-storage deal, investors should first project stabilized (that is, after rehab) operating results. Known as pro formas, these projected operating results help investors project future property results. To create these tools, we recommend beginning with the top-line metric – unit rents.
During the due diligence process of any deal, investors need to collect detailed information about each storage unit (e.g. square footage, current rent and lease terms, historic vacancy rates, etc.) and the property as a whole. This information serves as the foundation to our analysis. But, as stated, we want to add value to this property, meaning we expect to charge a future premium for rents. This premium differs by deal. But, by looking at rental comps for nearby self-storage facilities, investors can determine a realistic premium. For example, investors may determine that, by adding security cameras and an automatic access gate, they can increase unit rents by 20%.
Self-Storage Underwriting Step 2: Confirm Operating Expenses
After projecting future rents, investors need to confirm future operating expenses. With self-storage facilities, value-add improvements typically don’t involve the units, themselves. A storage unit is a storage unit. Instead, investors tend to improve the ancillary services. For instance, you may want to add on-site management, or install security cameras, or pave a previously gravel lot, or any other number of items that increase the efficiency and value of the property.
When you look at these improvements, you need to add any recurring expenses to the current operating expenses. In other words, if you plan on installing a security system, the monthly fee will become part of your stabilized operating expenses. Next, investors must combine these new expenses with the current operating expenses. Historical results can provide key insight here. For example, if you review electricity usage for the past three years, you can accurately forecast future electricity expenses.
While operating expenses vary by property, some common ones exist across all self-storage properties:
- On-site management fee (as required)
- Security system fees (automated and/or in-person)
- Utilities
- Janitorial fees
- Marketing fees
- Property taxes
- Insurance
- Maintenance
- Accounting fees
These projected expenses complete the operating pro forma. Once confirmed, investors will have a clear picture of stabilized net operating income (NOI), that is, rental revenue minus operating expenses.
NOTE: Renovation and improvement costs are not included in operating pro formas. These constitute capitalized costs that go into the property’s taxable basis – not its operating results. Furthermore, mortgage interest and depreciation do not qualify as operating expenses, so they should not be included in an operating pro forma (we will account for these expenses later). Rather, these two expenses fall “beneath the line” – part of net income but not net operating income.
Self-Storage Underwriting Step 3: Determine Property Value
After building the stabilized property operating pro forma, investors can determine its after-rehab value, or ARV. This number drives permanent financing availability and can make or break a deal. To accomplish this, investors use the commercial value formula:
Property Value = NOI / Capitalization (“Cap”) Rate
The pro forma provides the NOI, and the cap rate depends on both the market and quality of the self-storage property. Conceptually, cap rate represents a property’s return on an all-cash deal. For instance, if an investor purchases a property with cash for $1,000,000, a $50,000 NOI means a 5% cap rate ($50,000 NOI / $1,000,000 value).
Generally speaking, the more stable and higher quality the property, the lower the cap rate. To determine a self-storage property’s cap rate, investors will need to look at A) the quality of the property relative to other self-storage facilities, and B) the local market conditions (real estate analytics firms can provide this insight).
For investors, this commercial value formula proves extremely significant. A slight increase in NOI can have a major effect on property value. For example, assume property improvements reduce operating expenses and increase rent, for a combined 20% increase in NOI. With the above numbers, that increases NOI from $50,000 to $60,000. At a 5% cap rate, this increases value from $1,000,000 to $1,200,000. And, say that the improvements in quality also reduced the cap rate from 5% to 4%. Now, the property value increases to $1,500,000 ($60,000 NOI / 4% cap rate).
Clearly, self-storage property improvements can have amplifying effects on a property’s value, which factors directly into the next step of the underwriting process.
Self-Storage Underwriting Step 4: Back into Permanent Financing Availability
With the after-rehab value determined above, investors can “back into” available permanent financing. As discussed, most investors purchase self-storage facilities with short-term commercial bridge loans, make improvements, and then refinance the bridge loan into a long-term mortgage.
Commercial mortgages – like their residential counterparts – work on a loan-to-value (LTV) basis. That is, lenders will issue a loan based on a property’s appraised value. For commercial mortgages, most lenders will provide loans up to 75% LTV. Using the above numbers, investors could expect a mortgage of $1,125,000 ($1,500,000 ARV x 75% LTV). This loan amount provides investors key guidance. With it, they know they can refinance a bridge loan balance up to $1,125,000. This ceiling will then inform the acquisition and rehab budgets in the next step.
Self-Storage Underwriting Step 5: Confirm Acquisition/Rehab Budget and Financing
The permanent financing determined above sets an upper limit to the acquisition and rehab budgets for a self-storage facility. That is, investors want to ensure that the lower-interest permanent financing can fully pay off the higher-interest bridge loan.
However, determining the detailed rehab budget requires close coordination with a general contractor. And for self-storage investments, value-add renovations will likely also include major automation and security improvements, requiring the services of specialists. Working with this team, investors confirm their rehab budget. For example, assume it will require $200,000 in improvements to drive the above 20% increase in NOI (combination of increased rents and reduced operating costs due to automation). Combine this with a $1,000,000 purchase price, and investors need to come up with $1,200,000.
With short-term bridge loans, a variety of options exist. But, most lenders base their loans on a property’s ARV. Common terms offer up to 60% of a self-storage property’s ARV, but not to exceed 90% of the purchase price. To determine loan amount, we thus must look to two numbers:
- 60% of ARV: $900,000 ($1,500,000 x 60%)
- 90% of purchase price: $900,000 ($1,000,000 x 60%)
As these numbers show, investors can expect to qualify for a bridge loan of $900,000, as 60% ARV doesn’t exceed 90% of purchase price (if it did, investors would be limited to the 90% ceiling). This number must be viewed through two lenses. First, investors need to confirm that their permanent financing will pay off the short-term bridge loan. In Step 4, we confirmed a permanent financing amount of $1,125,000. This provides a $225,000 buffer for short-term loan interest payments, which typically roll into the loan balance until a predetermined date ($1,125,000 permanent mortgage – $900,000 bridge loan).
But, investors must also view this bridge loan amount through a contributed capital lens. As outlined, the purchase and rehab budget totals $1,200,000 ($1,000,000 purchase + $200,000 in capital improvements). But, the bridge loan only covers $900,000 of that amount. This means investors must contribute $300,000 of capital to make the deal work. If able to raise this cash, the investors will eventually control a $1,500,000 self-storage building for a $300,000 capital contribution.
Alternatively, investors could use gap financing to cover a percentage of this $300,000 requirement, knowing that a portion of the refinance proceeds could pay down the balance. This increases risk and interest expense, but it can also create a means of controlling this self-storage property for significantly less than $300,000 in contributed capital.
Self-Storage Underwriting Step 6: Project Cash Flows and Assess Investment Criteria
At this point in the underwriting process, investors have confirmed their operating pro forma, total contributed capital, and permanent mortgage debt service amounts. Next, they need to determine the deal’s exit criteria. That is, when will they sell the self-storage property, and what investment hurdles must the deal meet? With this information, investors can project A) an exit cap rate (to inform market value at sale), and B) property cash flows through the deal exit.
Again, analytics firms can project future cap rates, but we suggest taking a conservative estimate (that is, err on the side of caution rather than accepting an inflated future exit price). To determine cash flows, investors only need to deduct debt service and anticipated long-term capital improvements from projected NOIs for the lifetime of the deal.
With this information, investors can complete the final step in the underwriting process: determining whether or not the numbers meet investment criteria. For longer-term, value-add deals like self-storage investments, internal rate of return (IRR) serves as a logical metric. Conceptually, IRR tells you the interest (technically, discount) rate at which the present value of future cash inflows equals the initial cash outflow ($300,000). Inserting initial costs, annual cash inflows, and the final sales price into an Excel spreadsheet will quickly solve for IRR.
This is the make-or-break moment in the underwriting process, when investors determine whether a deal’s numbers support their investment criteria. For example, assume this team has a self-storage investment hurdle rate of 12% for a five-year deal. If the projected IRR comes in at 15%, the deal passes muster and should be pursued. On the other hand, an 8% IRR suggests the returns don’t justify the investment. When this happens, investors can either A) negotiate a lower purchase price to increase their IRR, or B) walk away from the deal.
Final Thoughts on Self Storage Deal Analysis and Underwriting
Self-storage properties can appear overwhelming to new investors. Most of us have lived in apartment buildings before, so we’re inherently more familiar with multifamily properties. But, as the above illustrates, the underwriting process for self-storage and multifamily deals is extremely similar. Self-storage investments certainly have unique considerations, but the process of analyzing deals does not significantly differ.
If you’d like to discuss different self-storage investment options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available investment opportunities.