One of the cardinal rules of investing in a self-storage facility is making sure you have your downside protected. To help facilitate this analysis, many buyers and lenders will “stress test” the proposed deal to see if they can survive the “worst case” scenario. In ths Self-Storage University podcast we’re going to explore the correct way to “stress test” a deal and what the key metrics need to prove in order to go forward.
Episode 100: The Power Of Stress-testing Transcript
When buying a self-storage facility, it's essential you always wear your white lab coat. You never get too optimistic on any deal, because you have to look at the numbers fairly, you have to look at them from a third party perspective, from an arm's length. You have to say to yourself, "Is this deal really gonna work out for me?" And one great way to do that is through stress testing. This is Frank Rolfe with The Self Storage University Podcast. We're gonna talk about stress testing a deal, how it works, and then what you can tell from the results of the stress test of whether you wanna buy that property or not. Now, why do we have to be negative on deals to begin with, it seemed to be so much more fun to be endlessly positive, but the problem is that being positive, being an optimist seldom relates to making money in real estate, because you miss the angle, the opposing view of what could go bad. So if you're buying a self-storage facility and you look at the numbers and you say, "Well, I can push this occupancy, I can push these rents, I can cut those costs."
Well, perhaps you can, but on the corollary, perhaps you can't. Because none of us really know how things work out, we always know there's that element of risk. If you look back in World War II, for example, Omar Bradley, the head of the army, he once said, "No great plan survives first contact with the enemy", that means the army could drop all kinds of big plans for invasions and other things, but the very first time they hit the opposing for us and they fired their artillery and they fought back, everything changed. Nothing worked the same. And even the invasion of Normandy by the United States, where we invaded France and we started to bring back the war, Eisenhower knew it's very possible it would fail, and he'd already written his speech admitting that it had failed and it was all his fault before they even landed or began the attack, and that's because we all should acknowledge we don't have full control over events. So knowing that if you embrace that, then the first thing you have to ask yourself in any deal is, alright, not only what happens if things go well, but what about if things don't go well. What if things go bad?
Some of us call this to doing a best case, worst case, realistic case scenario, best being that everything you hope for works out real that halfway, you get. But worst case, nothing good happens. You thought the occupancy would go up from 80% to 90%, but it said it stays flat at 80 or maybe even declines. You thought you had raised the rates, but suddenly through a lot of vacancy, the rates decline. What happens to you? That's what modeling a worst case is. And for many bankers, they call this stress testing. Now, you've all see the situation where the person, they probably are a little overweight, they put him on a treadmill with all these monitoring devices, and they push them as hard as they can to see where their body actually starts getting into danger, that's called stress testing, that's trying to figure out where your heart stands and your veins and everything in relation to day-to-day activities, to know what's safe for you and if you need additional work to rehabilitate yourself so that you're healthier. The same is true of any self-storage facility. So how then do you stress test? Well, you simply take ratios and you push, for example, the occupancy down to see where you break. At what point can you have a decline in occupancy such that you can't pay the mortgage.
Same with the rates, you could take any feature of that self storage facility, you can say, what would happen if suddenly there's a problem with the roof or some other physical constraint? What's the negative impact from that? And that allows you to see just how much room you have for error. Now, a well-constructed deal is going to have a worst case scenario that you can survive, but a poorly constructed deal will have a worst case scenario where you lose the property, lose your down payment. Sam Zell was the number one investor in American history, he died a couple of years ago, but he had been the largest owner of office buildings, apartment buildings, and mobile home parks in America, and he had a simple rule on life, he even told all of his employees here's his simple 3-point theory. Number one, any deal that has low risk, but high reward, you should always buy, every deal that has high risk and low reward you should never buy, and every deal that has high risk and high reward, those are the ones we should talk about. Clearly when you're ascertaining risk, risk ties back to stress testing, it ties back to worst case scenario. Not the scenario we all optimistically want to think about or ponder, but the reality that things don't always work out as you hoped.
The bottom line is, it's very, very smart for any investor to stress test their deal. There's many self storage facilities right now in terrible economic trouble, particularly in a lot of large cities, many in the north. Where people are fleeing from those cities going to other markets where they feel are safer, that they feel has more economic vitality. And a lot of what happened to the self-storage facilities are crashing in those markets is they did not do proper stress testing, they never thought what if, on a bad side. They only thought about what if, on the good side. For a smart investor, you've gotta do both. You've got to always stress test to consider your worst case and never buy anything if you can't survive it. This is Frank Rolfe of The Self Storage University Podcast. I hope you enjoyed this talk. To you again soon.