Last month we polished up our "mirror on the wall" to see which real estate is the "fairest of them all." Not surprisingly, we found in the initial stage of our review that a very good argument could be made that self storage is the fairest. However, I must admit that I have saved the best parts of my argument for my last installment of our little tale. The conclusion doesn’t change, of course, I’ve just added some more persuasive points to an already bright light in our reflections on the best type investment real estate. I am going to briefly explain five reasons why the cash flows on self-storage are higher and probably more secure than investments in other kinds of real estate. This translates to higher returns on your investment, less risk and possibly higher prices sometime in the future. All of my arguments, however, are based on the fact that a facility is in a good location, in a rational market (i.e. not overbuilt) and well maintained. Even though we believe self-storage is the best real estate investment, this doesn’t mean that it will bail out "dumb deals."

Zoning: We all know that getting zoning for self-storage is getting harder in almost every community. It is not that self storage is a bad civic citizen (actually it’s among the best), but that self storage is not glamorous, there are no sales taxes and the real estate taxes are usually modest. What right thinking planning commission would ever approve a project that had no glamour and didn’t produce a lot of taxes. This, of course, tends to restrict potential additional development and thus increase cash returns of existing facilities as demand builds. Thus, if you have a good facility, it is increasing likely that the local zoning board will not jump through hoops to help developers build potential competition.

Cap Rates: In the attached chart (see Chart I), compliments of Ray Wilson of Charles Ray Wilson & Associates. Ray has provided some national averages of cap rates on different, competing real estate types. Cap rates are really the annual return you can expect on your investment (i.e. 9 cap = 9% etc.). As the chart shows the returns on self storage are generally higher than most other real estate types. At first glance this looks like only a "so what" difference, but closer examination shows that the investment will yield 10% to 20% more in annual cash for the same dollar of purchase price. If you leverage your investment, (i.e. get a mortgage) the difference in cash on cash returns becomes truly impressive. For example, compare a self storage facility at a 10 cap rate and another real estate investment with the same NOI ( Net Operating Income), at an 8.5 cap rate with leverage (mortgage @75% LTV, 7.5% and 25yr. amort). The cash on cash return on the self storage is 13.1% versus 7.4% on the other investment – a 77% increase in return because of a 1.5% change in cap rate (see Chart II).

Capital Risks: Often times investors for investors for other types of real estate investments overlook the requirement (and risk) for additional capital. Hotels always need new furnishing and redecorating, office buildings literally eat massive amounts of tenant finish and commissions, apartments need everything and often. (If you would like some detail comparisons drop us an email and we will send you some startling numbers on this capital demand). However, as one industry wag puts it, self-storage also has its own capital requirements to handle tenant replacements, a new broom about every three months! While somewhat facetious, the capital demands of a self storage facility are very small, not only in relative terms to other real estate but also in absolute terms. A "standard" reserve for capital in the industry is about 10 cents per square foot. An example may prove helpful to demonstrate this issue. In an office building the amortization of a typical tenant finish allowance ($25) and commission ($5) over seven years would be $4.66 per square foot per year with interest at 10%. The reality is that all of the costs are expanded up front and not amortized. A typical self storage rent might be $12/SF/YR with $3.50/SF/YR in operating expenses (including reserves) for a net of $8.50/SF/YR. The office rent might be $24/SF/YR with $8.50/SF/YR in expenses, $4.66 of capital amortization, for a net of $10.84/SF/YR. The self storage probably cost less than $50/SF to build, the office building costs at least $125/SF to build. The uncertainty of the amount and timing of the capital costs compound the risk of the large capital requirements. In other words the capital may not be available at the time of need, such as a large tenant move out. After looking at the example, I will let you be the judge of which type of real estate appears to be the best investment.

Operating Costs: Once again self-storage appears to have an advantage because the operating costs for self storage usually have only a small exposure to volatile energy costs and labor. Many other real estate types have as much as 70% of their operating costs in energy and labor. Because of the lack of exposure to dramatic changes in these key expense components, the risk for self storage is reduced and the consistency of income is improved.

However, one of the main reasons that self-storage is such a great real estate investment is both a blessing and also a curse. The reason, of course, is the lack of glamour or as one of my friends in the self storage finance business says, "no glass and granite!" It is a blessing because all of the return comes in the form of cash flow and not ego satisfaction. While you probably won’t hold your daughters wedding reception in the parking lot of your facility, you might use your ballroom if you owned a hotel. But on the other hand you will have the cash to rent the place she really wants. The curse, however, comes when you sell your facility. Buyers are seldom ever so smitten with a self-storage facility that they fall in "love" with a project and forget the "numbers." The usual buyer of self-storage is someone just like you, in it for the money. In almost every case the buyer of a facility already owns a storage facility, knows the market cap rates, the operating costs and refuses to over-pay for a facility. Thus it is unlikely that you will find the "greater fool" that will pay above market cap rates or the non self storage investor that will take the time and energy to understand the product and bid up the price to his own detriment. Thus while we can earn the great returns as owners, we aren’t likely in the current market to sell a project on cap rates much different than we bought the facility, although from time to time cap rates do vary somewhat. Sometime in the future, as the market gets better educated on self storage, we may see these cap rates decline some what and increase our selling prices, but in the meantime just enjoy the returns.

In summary, when someone asks the question "Mirror, mirror on the wall who is the fairest of them all?", it is likely that if the mirror provides an accurate reflection there will be a series of bright blue garage doors staring back at the questioner.