Many of the self-storage deals out there are wholly unappealing. So what does it take to make a storage facility acquisition compelling? In this Self-Storage University podcast we’re going to explore the metrics behind evaluating a property and come to some conclusions on what should make you interested as well as what should make you run away.
Episode 121: Performance Anxiety Transcript
There's a lot of bad self storage deals out there and I would rather not buy anything than buy something that's going to lose money or not have very good performance. So how do you evaluate, how do you put in stacks? Storage deals you'd want to buy from, storage deals you'd want to avoid. This is Frank Rolfe with Self Storage University Podcast. We're going to go over what makes a storage deal compelling or compelling for you enough for you to even want to give it regular consideration. And let's start off talking about what's wrong in the storage industry, which is that there's many deals out there that aren't compelling. Look at the numbers of things offered by brokers, things on online listings. Sellers are simply asking too much. Now, how did that occur? Well, what happened was everyone had a price in mind if they were to sell. Kind of set in stone prior to the first quarter of 2022. And then what happened is Jerome Powell took interest rates up higher and faster than he ever had before. And suddenly we were thrust into an environment where we were at 40-year highs in interest rates.
Which means you'd have to go back in time to the era of Jimmy Carter and Ronald Reagan to hit rates as high as rates are right now on commercial loans. And when that was set in motion, when interest rates went up double or even triple in some cases from what they were at banks prior to Powell's actions, it made storage unit values plummet. Yet many sellers don't want to acknowledge that they want to live in the past. They say, well, I don't care what's going on, I still want X. And the problem is X is simply not achievable. So a lot of the things you'll look at today, you'll say, these numbers make no sense. Why would I even want to buy something at this lower rate of return? And many, many operators, particularly people who are just starting up, people who are looking in the wrong spots, alias urban markets, people who are trying to place a lot of money quickly put themselves in a terrible position and there's really no way to bail them out. They simply overpaid and they're stuck with that decision for the rest of their lives. But it doesn't mean you have to share in their misery.
You shouldn't have no interest in buying those deals at those very poor metrics of performance. So then what does make a deal compelling? What can you do today to find a deal that makes you really, really want to buy it? What are some of the issues that you have that you need to have as far as looking and evaluating a property to make you want to pull the trigger and do it well. Let's first start off with cash on cash return. That's always been kind of the gold standard of real estate. And Warren Buffett, who's known as America's greatest stock investor of all time, his lifetime average cash on cash return was 19.8%. So if you want to be like Warren Buffett, you need to get roughly a 20% cash on cash return. Now that's only possible in buying real estate and buying self storage property when there's a three point spread between the interest rate and the cap rate. When you have a three point spread, you are then capable attainable of hitting a 20% cash on cash return. And personally, I don't think it's worth buying a storage facility if you don't think you can get there.
So if you're looking at a property and you don't think you can go ahead and get it up to those lofty levels, then I'm not sure I would want to get involved in it. So cash on cash return is very, very important. If you bought something at a 10% cash on cash return, which is just a 1 point spread between interest rate and cap rate, well, that might be okay for many investors, but I would still urge you only to buy things where you can still raise it up higher over time. Another gold standard part of buying a storage facility is some kind of multiplier of your down payment, which equals a certain level of profit. So if you're going to go out there and risk, let's say $300,000 down payment on storage facility, you're probably going to want to make at least $300,000 of profit in the end, right? Double your money, maybe you want to get triple your money. But you're not going to want to buy that storage facility and put down $300,000 to try and make $50,000 of profit. So there has to be a healthy amount of return on your money to make it worth that risk.
And speaking of risk, don't forget Sam Zell's formula on risk versus reward. Zell was one of the largest and most successful real estate investors of all time. He passed away about two years ago, but he was such a believer in risk versus reward that even on his business card, he would put as a reminder to people inside his company that if a deal has high reward and little risk, you should always buy it. If it has high risk and low reward, you should Never buy it. And if it has high risk and high reward, those are the only deals to ask him about to get his feeling, his gut instinct on those. And again, if you're looking at buying a self storage facility, it's got to have ample reward for the amount of risk. Now what makes deals more risky? Things that have low occupancy, strange locations, more rural orientation, those things you have to have a higher rate of return. So look at your deal on a risk reward basis. Also look at what your options are as far as long term enhancing your position through financing. If you can get a property up by 50% in value, you can theoretically do a cash out refinance.
To many people that's again a gold standard unit of measure is could they do a cash out refinance. Now if you can't get non recourse debt on your cash out refinance, it really isn't that great a business model. So to get there you're going to have to have a property that's able to get what's called conduit or CMBS financing to get the job done. But can you boost the value of the property up by 50%? And the answer is yes. And if the deal would at that point be over a million dollars in size, then you might be able to do a cash out refinance with it. Another good thing to do with a self storage deal is go to the end of the movie and work backwards and do a best case, worst case, realistic case scenario. And the key item here is to basically stress test your deal and see how it turns out. Because nobody wants to own a storage deal that has negative cash flow where you have to feed it every month. So if your worst case scenario is that if you're buying something at 70% occupancy and you say well I may not get it ever up, well then at least needs to at least cash flow.
So that would be your worst case scenario. If you look at the best case, which is what would happen if you got the occupancy up to 95% and that's hugely attractive. Okay, that's a plus. And then realistic case is somewhere between the two, maybe you are able to exceed your going in occupancy and get halfway towards your best case. And if those numbers are attractive, once again, that's getting the deal a little bit more compelling. Also, don't forget, whatever you buy, when you're doing your calculations of the rates of return and the cap rates, you've got to use all the other expenses you will have in bringing that property back to life. If it needs a new roof, if it needs to have everything paved, those are big capital items and you have to add that into your total purchase price or you're not really being fair to yourself as far as the rate of return. So make sure you don't cheat. Make sure you take not only what you're going to have to pay, but all those other improvements, because that's always going to have a big impact on you. The bottom line to it is that everyone has their own idea of what is truly compelling and what is not.
No one can answer that question for you. But when you see a lot of deals out there and you say, well, gosh, why would anyone buy it at this kind of rate of return, then that's a good clue. You shouldn't be doing it. Don't be stepping in the shoes of other people's misfortune or bad mistakes they made. And also, don't let sellers ever try and convince you that somehow you're not a player because you're not interested in the stuff they have to offer. They often try and psychologically convince you that you're wrong, that they're right, that those numbers really are positive, and things you want to embrace when the answer is no. And the same with brokers. A lot of brokers obviously are pushing deals out there because they want to get a commission, but they know better. But they have no skin in the game. If they convince you to buy it, well, then it's your problem. After closing, they got paid, you moved down the highway. They don't really care. So again, just like with those sellers, don't let the broker somehow convince you that you're wrong. You don't understand the business, that you're basically ignorant of how numbers really work, because you're not.
We see all the time people out there hawking things which they know better. They know they're not attractive, yet they try and convince you that they are. So stick to your guns, don't reduce your criteria, use common sense, and you'll do very well in picking the deal that's right for you. This is Frank Rolfe with the Self Storage University Podcast. Hope you enjoyed this. Talk to you again soon.