Compared to recent years, 2024 may be a challenging time to develop a new self-storage facility; however, opportunities still exist. You just need to be more mindful of economic conditions and market dynamics. Let’s look at some of the key factors impacting industry construction activity this year and items to analyze when assessing the viability of a specific location.
Not long ago, the combination of low interest rates and increased consumer demand for self-storage created an unprecedented boon in facility development. However, due to rampant, post-COVID pandemic inflation, interest rates have risen, construction costs have increased and rental demand has softened. There were loads of deals that “penciled out” when interest rates were 4% and construction costs were $40 per square foot. Unfortunately, those days are in the past.
Some in the industry have estimated that 70% to 90% of planned self-storage projects have been paused or canceled due to interest-rate escalation. Don’t let this scare you, though. Plenty of facilities are still being built. They just have to be stronger financially.
Assuming you have a self-storage project with good economics, don’t wait! The best time to get a development into the construction pipeline is when everyone else is on the sidelines. By the time your facility is brought online, it’ll likely be the only new supply in the market.
Many self-storage operators, most notably the real estate investment trusts (REITs), have been very aggressive in lowering their street rates in markets with softening demand. They’re also actively increasing those rates once tenants are in the door; but as we’re only privy to their published data, we don’t know by how much and how often. This can complicate matters when attempting to analyze a potential new market.
The best way to combat this lack of information is to widen the pool of competitors you examine when determining self-storage market rates. Make sure non-REITs are a part of your pool. If possible, use software that compares 12-month trailing rental rates against current prices.
One way to determine rate affordability is to consider the cost of occupancy. To calculate this figure, you simply take the annual cost of a 10-by-10 self-storage unit and divide it by the market’s average household income. For example, if the unit is $120 per month (or $1,440 per year), and the average household income is $140,000, the cost of occupancy is 1%. If household income were only $50,000 per year, the rate would increase to 2.8%, which is less sustainable.
According to the “2023 Self Storage Almanac,” if the cost of occupancy is below 3.5%, rental rates are affordable. If higher, they’re too expensive. Of course, this calculation can be useless if you’re in a supply-constrained market or there are larger macroeconomic factors at play; but it’s a helpful metric to consider, nonetheless.
More Specific Factors to Consider
Of course, there are many other market conditions to consider. With higher interest rates and construction costs, increased competition and softening demand, there’s significantly less room for error when underwriting a self-storage development. This is where a detailed feasibility study can help. If done correctly, it should eliminate many uncertainties. A good report will examine the following:
Site-inherent risk. The feasibility study should first and foremost look at your site’s zoning, environmental conditions and topography to identify potential deal-killers. This won’t replace the services of a civil engineer or environmental consultant, but it should identify potential issues up front. This analysis should also look at the property through the eyes of a potential tenant, analyzing its visibility and accessibility.
Demographics. This portion of the analysis should identify the site’s primary and secondary markets and examine key customer characteristics. It should identify trends in population growth, household income, homeownership, commute times and other metrics to help you understand your potential renter base.
Supply and demand. The goal of this section is to determine how oversupplied or undersupplied your market is. A common approach is to calculate the rentable square feet of self-storage per capita in the market, then project future supply by accounting for incoming projects. While there are industry resources and software that are great at tracking planned and in-progress projects, it’s easy in these market conditions for a project to be sidelined or outright canceled. Make sure your feasibility consultant reaches out to local planning or building departments to get up-to-date information.
Future self-storage demand is forecast by looking at a combination of population-growth trends, income, and state and regional demand, among other factors, to come up with a target for rentable square feet per capita. If demand exceeds supply, your market is undersupplied.
Competition. One of the most important pieces of a feasibility report is the competitor study. On paper, a market may be significantly oversupplied; but when you call other facilities in the area, you may find they’re all full with a waiting list. Make sure your consultant is calling the five or six closest self-storage properties and having live conversations with the operator. You’ll be surprised at how much you’ll learn about the market.
Rental rates. An analysis of local self-storage unit pricing should yield recommendations for your own rental rates based on a combination of competitor and historical data as well as other demographics. Competitor prices should be weighted according to distance from your target location and other site attributes such as traffic, age, access, building configuration, etc.
Unit mix. If you don’t already have a unit mix, the feasibility study should make a target recommendation. In general, a variety of sizes should be offered to capture all potential customers. For example, businesses tend to rent larger units and residential renters lean toward smaller spaces. Offering a wide selection helps you appeal to both segments.
Construction budget. A preliminary cost budget should be included in your self-storage feasibility study. This is used to calculate investment returns. Note that final costs will vary widely after accounting for planning and engineering.
The Financial Analysis
This is the most important piece of a self-storage feasibility study, as it seeks to answer: Does my project make financial sense? And if so, what is my expected return? The financial analysis should give you multiple metrics by which to judge your potential investment including cash-on-cash return, internal rate of return, debt yield and debt-coverage ratio. These are all figures your lender or investors will want to see, too.
There are many assumptions that go into the self-storage financial analysis. Be mindful of the phrase, “garbage in, garbage out.” This means that if your assumptions are bad, your conclusions will be unreliable. The numbers that go into the pro forma will never be perfect, but they should be as close as possible.
On the revenue side, make sure your rental rates accurately reflect the market and that all profit centers are identified, such as retail merchandise, truck rentals, fee income and tenant insurance. The lease-up period should also reflect reality. In general, the higher the market occupancy, the quicker the self-storage facility will fill.
For operating expenses, make sure you understand your management structure. For example, a facility with an onsite staff is more expensive to operate than one that is remotely managed. Another large-ticket item is property tax. Make sure your feasibility consultant calculates the bill for multiple market competitors to best gauge what your taxes will be.
The same is true for sale and financing assumptions. Make sure the terms of the construction loan and terminal capitalization (cap) rate reflect the current market. Interest rates and cap rates change regularly in today’s environment.
Scrutiny Is Required
The self-storage development boom of the last few years may be over, but there’s still room for savvy builders and investors to get in the game or expand their portfolios. With softening demand and higher interest rates, extra scrutiny is required to ensure your proposed project is a smart investment. By following the above advice, you’ll be well-equipped to move forward when you identify a viable opportunity.
Derek Walker is a principal of self-storage consulting firm Box Pro, which specializes in feasibility studies. He also develops and manages properties for Storage of America, which operates 25 facilities in five states. To reach him, call 801.839.5844 or email [email protected].