3 Self Storage Signals to Watch This Summer

As the sector comes back to earth, Gantry's Amit Tyagi highlights critical dynamics for borrowers.

self storage
Amit Tyagi

Each commercial real estate asset class is facing its own set of challenges in the current market cycle. From softening demand drivers to simply ongoing rate volatility and a current “higher for longer” prognosis, or both. Self storage, while a resilient asset class with enviable performance during this tumultuous shift, is no exception. After years of phenomenal performance, a return to normalcy is feeling like heartburn in some cases.

This summer will be a season to pay attention to as we continue to monitor Federal monetary policy looking towards fall, consumer behavior in a cooling economy, and the general accessibility of reasonably priced debt capital. Macroeconomic forces are beginning to shift in both subtle and marked ways, and these pile-ons will have an impact on CRE in general and self storage in some specific ways.

Here are three current themes relevant to self-storage lenders and sponsors alike: rent performance, interest rates, and economic/demographic shifts. All three will play a role in successful financings during this challenging cycle.

Street rates vs. in-place rates

According to an April survey from RentCafe of the 150 largest U.S. cities, street rates are dropping by a substantial measure across the country. This makes underwriting self storage assets more difficult as source data is confused by current industry marketing strategies, leading many to interpret findings as a downward trend for facility performance. The biggest disruption to the easy underwriting of the past decade is today’s growing confusion over how street rates (or now more often web rates) vs. in-place rents and revenue growth can better determine asset performance.

Most lenders continue look to a survey of local advertised rates of nearby competitive facilities to build a performance gauge for a given asset, but the veracity of this approach is no longer as telling. Many operators are now advertising cheap introductory rates subsidized by marketing budgets designed to capture new clients. But you must remember that these rates are planned to increase over time, and these increases can happen very quickly and to a large magnitude. High-performing facilities with street rates that are half of what they have been in the past are still seeing total revenue grow at the facility level. For most assets, we find in-place rental growth continues to buoy positive performance. These low introductory street rates rapidly transition higher, leading to sustained year-over-year total revenue growth.

This shift in data points is requiring a deeper dive into performance during underwriting. As if the industry needed another complication!! We are spending far more time with self storage lenders digging into true asset performance and seeking a more sophisticated story. This often entails separating a rent roll into increments of length of tenancy of less than 30, 60 to 90, 90 to 180, and 180 days of occupancy and beyond. “How long are they staying?” and “which group is having the most move-outs?” have become questions we’re fielding more often. Industry-wide investments in facility quality, efficiencies, and accessibility are keeping tenants for longer. This is resulting in continued performance during a tough market cycle.

Getting this analysis to display the right story will be priority for all parties involved in financing, bolstering lender confidence which will generate better outcomes for borrowers. While this extra work complicates what for many years seemed a turnkey rental comp process, it results in more realistic assessments translating to appropriate valuations, reasonable loan proceeds, and ultimately better rates in this market.

Rate volatility and active lenders

We are beginning to see results from the Federal Reserve’s quest to lower inflation through this “higher-for-longer” rate strategy. That can be seen in the fact that rates have held, albeit at new highs, over several meetings, and the case for future rate decreases by the end of 2024 is still in play. While this higher rate cycle is causing pain, there are still viable financing options at current levels for most assets commiserate with investment goals.

Insurance companies remain the preferred lender for most permanent debt, although CMBS has made a dramatic return this year. For projects in transition or new construction, debt funds and select banks are viable sources. Debt funds are simply expensive starting with SOFR as an index, but alive and well. Banks are not as reliable a lending source as they used to be, but they are open for business. Bank loans now come with a more onerous list of requirements like deposits, recourse, treasury management relationships, etc. Banks are still feeling the squeeze of the higher interest rate environment and a big question mark is the troubled loans held on balance sheets that will need to work their way through the system.

With the current climate in mind, we are seeing permanent loans from life companies price at roughly 6 percent and up to about 7 percent, with CMBS coming in higher at 6.5 percent to 7.5 percent. Bridge lenders are ranging from 7.5 percent at the lower end to between 8 percent and 10 percent plus at the higher end of the range. New construction is seeing banks (if other considerations can be met) pricing in the 8.5 percent plus range, with debt funds at 10 percent and higher. Leverage will also play a role for borrowers, as the best rates will be reserved for those pursuing low leverage financings. Conservative leverage in this cycle will come in at around 45 percent or less to secure rates at the lowest end of the spectrum.

If this is the worst-case scenario for the year, we are still in a viable financing market for most borrowers. These rates are higher than we’ve experienced over the past decade, but most sponsors can still meet DSCR or revenue projections on viable business plans. If current rates hold through summer with hopeful rate reductions by Fall, this can still be a productive year.

Demand trends

The final piece of the puzzle will ultimately be in how the economy functions in what has become a strategic cooling period. Will we find the elusive soft landing, or will a recession emerge as we’ve seen coming out of inflationary environments in the past? Recent inflation data points to some easing, which bodes well for those predicting 2024 rate decreases. The results from this cooling will undoubtedly have effects on self storage demand.

Many attribute the steep drop in housing sales in this higher rate climate as a major contributor to the cooling self storage market. Home sales have declined substantially over the past 18 months due to higher mortgage rates and home prices remaining stickier than expected. Demographic trends like population migration that shaped demand for self storage in high growth markets (like the Sunbelt) have eased. Many high growth markets are feeling the effects of recent self storage supply influx. This will require working through current inventory over an extended period, which should happen over time but will restrict new construction starts this year.

If we begin to see rates decrease later this year, we should expect to see improving self storage demand resulting from a housing sector that should pick up in activity. Well-located self storage facilities continue to benefit from smaller and smaller footprint housing being built in many primary markets. This will continue to play out in top tier MSAs, where high barriers to entry and growing populations will continue to support healthy self storage demand for the mid- to long-term.

Ultimately, the fundamentals remain strong for self storage, even in this tough cycle. While we cannot predict where we will be by the end of the year, our optimism requires realistic assessments as we hope for the best and simultaneously remain prepared for any more bumps in the road. Pay attention this summer indeed.

Amit Tyagi is a principle of Gantry.

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