Why Self Storage Is the Exception to the Rule

This asset class defies the conventional wisdom that real estate is hard to finance, according to Gantry's Tom Dao.

Tom Dao

The strength of the self-storage asset class over the past decade has not gone unnoticed. Coming out of this year’s annual 2023 Mortgage Bankers Association Commercial Real Estate Finance conference in February, it is now clearly seen as one of the most attractive asset classes for lenders moving into the year ahead—right alongside industrial and multifamily. This year’s conference reflected on the 300+ basis point uptick in interest rates since last year’s meeting and how each asset class is responding to the new rate climate and broader market disruptions. Self storage is not only surviving but thriving.

Many of the sector’s champions point to the fact that self storage performs well in all market conditions as a buoy for confidence in continued performance. It has done particularly well in the past three years and continues to show strength in the face of increasing interest rates. Vacancy overall is holding well below 10 percent, which bodes well for continued rent growth. Increases to inventory from construction in the primary and secondary markets across the nation are also holding below 10 percent outside of a few key sunbelt growth markets. For new projects, stabilization is moving on average from a two- to three-year window to three- to four-year window, but absorption is still considered robust. Rent increase expectations are expected to range on average from to 2 percent to 5  annually, although for many existing facilities charging under market rents, we can see greater increase potentials as rates are brought up to market. These are strong fundamentals for lenders.

In general, it was evident coming out of the conference that banks have not responded well to broader market uncertainty. Most of the large “money center” banks are effectively out of the market. Those that are in the market may seek a large depository relationship due to a growing liquidity shortage. Long a favored lender for self-storage permanent debt, CMBS lenders are often seen today as a lender of last resort due to rate volatility and coupon uncertainty until close. These factors are making life company lenders the go-to source for permanent and bridge debt in the sector at this point in the cycle, and while many borrowers are opting for shorter-term solutions, long-term permanent debt is being made available by these lenders with significant prepayment flexibility built in to attract the best assets.

Negative Leverage Surmountable

One of the general drawbacks in the current market climate for CRE lending is the higher cost of financing eating into debt service coverage. For most asset classes, this makes financing at current rates and property valuations untenable. However, negative leverage is seen as a surmountable reality in self storage, a characteristic that other asset classes will struggle to emulate. The ability to adjust rents on a month-to-month basis will allow the asset class to keep up with inflation and to increase NOI on an expedited timeline through strategic rental growth, putting the asset class in a unique position.

Knowing this, life company lenders are making permanent debt available to un-stabilized self-storage properties where sponsorship is experienced, and a functioning business model is in place. Over the past decade, Gantry has worked diligently to educate our correspondent life company lenders on the nuances of self-storage underwriting, and their appetite for the asset class has grown. Stabilized assets continue to get strong looks from institutional investors and permanent debt is available even when assets are trading at lower cap rates and potential negative leverage, oftentimes an assumed risk because of aforementioned rent growth potential.

In the value-add acquisition space, funding options, including shorter-term instruments from debt funds and bridge lenders, remain available with the latter including some life companies. For any acquisition in this format, the ability to prove out viable rent increases to meet market rates will be the key to sourcing strong options that may begin at negative leverage but transfer to positive leverage shortly thereafter with effective execution.

All in all, 2023 promises to be a strong year for self-storage finance, making the asset class the proverbial exception to many rules.

Tom Dao is a principal of Gantry.

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