As a commercial property type, self storage offers investors outstanding long-term growth and cash flow opportunities. These properties tend to have far lower operating costs than their multifamily counterparts, and renters tend to stay put once they occupy a storage unit. But, for people looking for a passive investment strategy, a couple common options exist. As such, what makes more sense when investing in self-storage properties: REITs or syndications?
We’ll use the rest of this article to discuss the general considerations of investing in self-storage properties via both REITs and syndications. Specifically, we’ll cover the following topics:
- The Advantages of Investing in Self Storage
- Self-Storage Investing: REITs
- Self-Storage Investing: Syndications
- Final Thoughts
The Advantages of Investing in Self Storage
For investors exploring different commercial real estate options, self storage provides the below advantages.
Relatively Low Operating Costs
Passive real estate investors frequently focus on multifamily property types. Most people have at some point in their lives lived in an apartment building, so this asset class has an inherent familiarity. Furthermore, many new investors just assume that apartment buildings have the best returns – people always need to live somewhere, right?
In reality, compared to multifamily properties, self storage averages significantly lower operating expenses on a per square foot basis. According to recent research, self-storage operating expenses average between $2.75 – $3.50/sq. ft. compared to $3.50 – $5.00/sq. ft. with multifamilies. And, the larger leases of apartments don’t outweigh these higher costs. That is, self-storage properties command a similar rent on a per square foot basis – between $7.5 – $12/sq. ft. for both property types. As a result, self storage tends to command higher average returns than multifamily properties.
Another major advantage to self-storage investing involves people’s typical approach to renting a storage unit. Once someone spends a Saturday afternoon moving extra stuff into a storage unit, it becomes an out-of-sight, out-of-mind phenomenon. Automatic payments exacerbate this situation, as tenants don’t even need to think about paying rent on a monthly basis – it just happens in the background.
Simply put, self-storage renters face too much inertia to justify moving. Many people just don’t have enough motivation to empty a storage unit after they’ve occupied it. This makes long-term tenancy extremely common throughout the self-storage industry.
Self storage also provides investors a solid portfolio hedge against economic downturns. With many commercial property types (e.g. offices, retail, industrials), performance parallels the broader economy. In a strong economy, they perform well. Conversely, in a weak economy, performance frequently suffers.
On the other hand, self-storage properties generally perform counter-cyclically. In economic downturns, people tend to A) go back to school, and B) downsize into smaller homes or apartments. Both of these paths lead to people having too much stuff for their new living spaces. Rather than throw things away, people often choose to move extra household goods into storage units. This creates a dynamic where, as the economy suffers, self-storage demand increases. This reality makes self storage an excellent counter-cyclical hedge in an investment portfolio.
While macabre to discuss, investors cannot ignore the effects that demographic trends will have on self-storage demand over the next several decades. In 2020, millennials finally surpassed baby boomers as America’s largest living adult generation.
Over the next 30+ years, as baby boomers pass away, their children will face the emotionally draining task of deciding what to do with their parents’ possessions. Rather than face the grief of sorting and throwing away these items, many children will compromise: move it into storage. This path saves the heartache of throwing away parents’ possessions, and it will inevitably increase demand for self-storage units for the foreseeable future.
Having outlined the advantages to self storage as an asset class, we’ll now explore the question: invest in self-storage REITs or syndication? By reviewing the below pros and cons to both paths, investors can decide which option makes the most sense for their unique financial situation.
Self-Storage Investing: REITs
Self-Storage REIT Overview
For passive real estate investors, real estate investment trusts, or REITs, offer a solid option. Similar to buying stocks, when investors purchase shares of a REIT, they purchase the company – not its underlying properties. The REIT itself operates the underlying real estate, and it pays out a high portion of its returns to investors.
Furthermore, most REITs focus on a particular real estate niche. As a result, investors can purchase shares of self-storage REITs, providing them exposure to the property type without the need to actually buy and manage a storage facility themselves.
Pros to Self-Storage Investing with REITs
- High dividends: By law, REITs must pay out at least 90% of their taxable income as dividends. For fixed-income investors, self-storage REITs combine the above property type advantages with a steady stream of dividends, typically far larger than those of mutual funds or individual stocks.
- High liquidity: Many REITs trade publicly. This makes shares in a self-storage REIT far more liquid than most other real estate investments. For investors who cannot afford to tie up a significant amount of capital in an illiquid asset, REITs provide exposure to self storage while remaining extremely liquid. Investors can purchase and sell these shares just like they would any other publicly-traded stocks or funds.
Cons to Self-Storage Investing with REITs
- Tax treatment: Unfortunately, the IRS doesn’t treat most REIT dividends as “qualified.” As a result, investors need to pay ordinary income tax rates – rather than the more preferential long-term capital gains rates – on most of these distributions. For high-income investors, this could mean a 37% federal rate instead of the 15% or 20% applied to qualified dividends. Due to this tax treatment, holding self-storage REITs in a tax-advantaged retirement account serves as a great tax strategy.
- Interest rate sensitivity: When publicly-traded, self-storage REITs face significant interest rate sensitivity. While all commercial real estate remains somewhat sensitive to rate fluctuations, REIT values fluctuate far more aggressively than the values of the underlying assets. Broadly speaking, as interest rates rise, REIT values decline. For investors focused solely on fixed-income generation, this may not pose a problem. But, if focused on capital preservation, REITs can be fairly volatile.
Self-Storage Investing: Syndications
Self-Storage Syndication Overview
Real estate syndications provide a vehicle for multiple investors to pool their capital in pursuit of a deal. Typically, a deal sponsor (or general partner) finds, plans, and executes a deal then manages its day-to-day operations. At the same time, a series of investors (or limited partners) provide the capital necessary to make the deal happen. Accordingly, the sponsor can move forward with the deal, and the investors gain an ownership stake in a property that someone else will manage.
Say, for example, a self-storage facility costs $2,000,000. To purchase it outright, a single investor would likely need at least a 20% down payment – $400,000. Alternatively, a deal sponsor could contribute part of that downpayment and create a syndication for investors to contribute the rest. If an investor contributes $100,000 to this $400,000 requirement, he or she would receive a 25% ownership stake in the deal.
Pros to Self-Storage Investing with Syndications
- Tax treatment: At face value, self-storage syndications don’t provide any better tax treatment than REITs, as investors must pay ordinary income rates on any rental income received. However, due to the fact that syndication investors directly own a portion of the underlying property, they receive pro rata shares of all income and expenses. As such, depreciation passes through to investors, which frequently creates a taxable loss despite positive cash flow.
- Returns: Syndications invest in single deals. Consequently, performance can vary greatly from deal to deal. But, in general, investing in a self-storage syndication will provide greater returns than investing that same capital in a self-storage REIT, especially when you factor in the above tax treatment.
Cons to Self-Storage Investing with Syndications
- Liquidity: As stated, investors in self-storage syndications directly own a stake of the property. This makes these investments extremely illiquid, that is, you cannot quickly convert a limited partnership stake in a syndication into cash. Instead, most syndications have clearly defined time horizons (e.g. 5- or 10-year deals). This means that you collect cash flows for the term of the deal and then receive a final payout upon sale of the asset. For investors who can’t afford to tie up capital for an extended period of time, this makes syndications a poor choice.
- Experience: As publicly-traded entities, REITs face a tremendous amount of regulatory scrutiny. Syndications, on the other hand, face far less oversight. This vastly increases the risk of A) fraud, and B) poor investment performance when investors join a syndication. Due to this risk, before investing in a self-storage syndication, investors should have a solid grasp of commercial real estate underwriting, with particular focus on self storage. Bottom line, investors need to screen these deals themselves, so they should never enter them without conducting serious due diligence.
As with most financial questions, no clear answer exists to the self-storage REIT vs syndication question. Rather, investors need to consider their unique situation and investment objectives. Generally speaking, investors looking for fixed-income performance in a tax-advantaged account would benefit from REITs. Conversely, investors focused on higher returns (and willing to accept the associated risk) who want the tax benefit of pass-through depreciation should consider syndications.
If you’d like to discuss different real estate investing 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 passive self-storage investment opportunities.