For a while, self-storage cap rates had been in the same ballpark as other sectors – most notably apartments – but now they are going up while housing sector cap rates are staying low. Why is this occurring and what can you do to protect yourself? That’s the subject of this Self-Storage University podcast. As you’ll see, there are legitimate reasons for this cap rate disparity, and important steps you can do to mitigate this risk going forward.
Episode 31: Why Storage Cap Rates Are Going Up And How To Protect Yourself Transcript
Things run in cycles, and so do self-storage cap rates. This is Frank Rolfe, the Self-Storage University Podcast. We're gonna explore what in the world's going on with self-storage cap rates right now, why they are going up in running locations and how to protect yourself. Let's first start off with why self-storage cap rates are suddenly going up. They had gone down for the longest time in line with interest rates and all of the real estate sectors, but suddenly they're going back up again. What could be causing this?
Well, there's I think four key reasons. The first reason is that the self-storage industry does not have access to that very attractive Fannie Mae and Freddie Mac financing what's known as agency death, which apartments and mobile home parks do enjoy. Those rates keep getting lower and lower and lower to insanely low levels, often down with a two on the front. So really, really low interest rates among the lowest we've ever seen. But storage can't tap into that. It's stuck in the world of seller financing, bank financing and CMBS conduit debt, all of which are more expensive on the interest rate than that agency dead option. So that's number one, because we all know that deals reflect interest rates, the cap rates have to give you a spread among interest rate to make a good return, so right now, cap rates are going up because the interest rates are seemingly going up as well.
The second reason is massive over-building. The self-storage industry has really messed up this time, doing about five billion square feet of new construction going right into the pandemic. Now instead of having a certain ability to take down so many vacant square feet prior, obviously, with the new pandemic numbers, that's really impacted that a lot. And to be honest with you, it's too much over-building to begin with, that traditionally always happens in any industry where there's no limitations on growth, people tend to always over build. As long as they can get the financing, well they go forward and build. People who build, they build because they get fees on the front end, and then they always think to themselves, "I can beat the guy next door because I'll have whatever," extra flags, or a better LED side. And they're always wrong, but that's what gives them the confidence to go ahead and break ground when they know they probably should not.
The third item is you're seeing just a general softness in urban areas, what's causing that? Well, several things. COVID didn't help much, because a lot of people with COVID had said, "Wait, I don't wanna be here surrounded by lots and lots of people. I wanna get out of town, I wanna have a lot more privacy, I wanna have a yard." And of course, a lot of urban unrest just scared people who say, "I don't feel safe anymore in the big city," so they're moving out in the country. Since most of the self-storage in America is in the big city, and all their customers are leaving. Well, then you can guess that will cause a certain amount of softness. And when you add all these together, the big one is just the perception by lenders, lenders are getting a little scared of self-storage.
Now, of course, you're getting scared because of that over building, you're getting scared because of the fact that people are leaving, leaving those big cities to move out of town. And so it really makes complete mathematical scientific sense why cap rates should be going up. But then it then begs the question, what can you do to protect yourself? If you wanna invest in self-storage, but rates are going up, what do you do? How do you invest? How do you make sure that you're gonna make money in the industry? Well, the first thing is, you need to buy at higher cap rates, don't let a broker or a seller convince you it's okay to buy this self-storage facility at this really low cap rate, because it's not.
What's gonna happen is if you pay too a low cap rate, you're going to at some point invert. You'll be paying more for that self-storage facility than it's actually worth, that means you're gonna lose money, it also means when you go to refinance, you might not be able to look for free finance. The appraiser may come back and say the thing is worth less than you paid unless you can cough up the capital, then you can't get another loan done. So more than ever before, it's very important right now to watch over the cap rates that you're buying out and make sure that you're buying them at a fairly high level. Right now, some of the most expensive deals, the nicest urban locations are being valued at cap rates of like 6 1/2 and 7%, so be realistic on your cap rates. The cycle is changing. Things are going up, not down. Make sure that you don't overpay. Number two, be sure and buy everything with a fair amount of fluff built in. What's fluff mean? Fluff means you wanna go ahead and put a little extra expense in there than you think you're gonna hit simply because you wanna give yourself a little additional room for air.
We all make mistakes. That's how life works. We all make mistakes in buying, we all make mistakes in our estimates. Just make sure you have a lot of fluff in there to cover those mistakes, so if you're thinking, "Well, I can probably increase the occupancy in this by 20% because I will do more effective online advertising." Well, I got news for you, you may not be able to, and that probably is not the budget you should run. Every buyer should use a best case, worst case, realistic case scenario, in every deal. Look at what is the best that can happen, what's the worst that can happen and then somewhere in between, what's the realistic case. You have to survive the worst case, because the worst case could happen and that fluff is gonna give you the tools and the weaponry to survive things when things don't go your way at all.
Next item, get out of urban markets. Now, I know America has been going more urban for the longest time, about 100 years now, I think back in the early 20th century, 1910-15. Coming out of World War I is when most people moved to the city. The city offer them more excitement, movie theatres, clubs, bars, the ability to meet more people, they just seemed all kinds of exciting. And as a country we've been running with that attitude for about a century now. But with the advent of COVID, with the advent of urban unrest, people are starting to question if that's really what they want in another life. A lot of young people are now questioning everything about life. How careers work, families work, the whole thing, and many people are finding they really just aren't happy in that urban setting.
So really the future, I think of American real estate is gonna be finding niches where you can invest in suburban and ex-urban markets. Self-storage gives you that opportunity. If you focus on self-storage in the suburbs and the exurbs. Now, for definitional purpose an exurb is that next ring of people residing just beyond suburban markets. So if your suburbs to a city might be 30 minutes out, the exurbs might be as much as an hour out. But that's the future, that's where people are going. Look online, read the maps, look at the little arrows showing movement in, and movement out. What are you seeing? You're seeing most Americans getting out of the urban areas and getting into suburban and ex-urban areas.
So that where your growth is going to be. There's also no problem with that, because that's where most of your really good mom and pop deals are located at. So right now, if you can buy that deal in the suburb or the exurb at a good price for mom and pop, this change of American demographics should push you farther and higher than you even imagine, even if you're not a very good operator. Just simply owning something in the path of progress has proven over hundreds of years to be a really, really good formula. Look at John Jacob Astor the first real estate millionaire. How did he do it? He just bought land. How was he so smart? Well, 'cause he brought almost the entire island of Manhattan, back then Manhattan was nothing, just rural area, but obviously it picked up. It became a big deal, and that's what filled his fortune, it wasn't his great intelligence on it.
Another observation of things you're going to see as far as how to harness the power of cap rates going up is you're gonna start seeing distressed properties. I don't know when, I don't know where. But obviously, many people who've bought at the height of the market at really low cap rates are about to get really, really burned. They're gonna get burned in a couple of arenas. Number one, cap rates going up, but the other is the general fleeing from those urban markets. I'd be terrified to see the numbers on some of these newly built self-storage facilities, mainly these multi-story climate-controlled things where all the customers are fleeing and you've got giant death and you model that at a really low cap rate.
What a nightmare. What's gonna happen there? Well, I think a lot of those are going to go in the foreclosure. A lot of deals are gonna go in into a distressed format. Now that's great if you're a buyer, terrible if you're a seller, really terrible if you're a banker. But again, you may start seeing at some point, self-storage facilities that you thought were massively overpriced and had no future, suddenly coming down to earth again. And when there's all finally crashed, when they splat on the ground, often you can get some really good buys, and that's a whole level of the market that people have not seen since the 2008 great recession. So that new opportunity may also just be soon around the corner.
The bottom line to it is there are winners and losers in every cycle, and right now we're entering a new cycle of storage, caps going up, population changing but that doesn't mean you can't still make money in the asset class. You just have to reorient yourself to the truth of what's going on, and you gotta not fight that, but go with the flow. Embrace what's going on. Harness the power. That's where the money is gonna be. This is Frank Rolfe, The Self-storage University podcast. Hope you enjoyed this and talk to you again soon.