Publication XIII

By Michael McCune
Argus Self Storage Sales Network

CAUSES OF OVERBUILDING (Building for Fun and Profit)

The causes are relatively simple. Investors, developers, lenders, and other interested parties find self-storage attractive and have reason to think that development of such a property could and should be profitable. Clearly, it is not difficult to argue that, in the current economic environment, self-storage is profitable. Given the historically low interest rates, low inflation on building costs, rental rate increases and low vacancies, a cursory analysis would suggest that the returns in self-storage are very attractive.

Returns from other types of real estate have gone down dramatically during the recent economic boom. For example, office buildings are trading at returns that are two or three percent less than self-storage. Thus, not only are the self-storage returns attractive in their own right, they become even more so when compared to the alternatives available in other types of real estate. Another factor driving the market is the ease of entry into the business created by the relatively small amounts of capital required to develop self-storage as compared to other real estate investment projects.

Additionally, local banks are more willing to make loans on self-storage development projects. Banks are aggressively seeking loans and are more than delighted to lend to a good customer, with adequate net worth, money to build a project. The end result often times is ill-conceived projects that ultimately compete solely on low rental rates.

An interesting side note is that many of your own self-storage customers are also potential competitors. How many times have you heard one of your customers say, What a great business this is and so simple to operate too The desire for quick Easy money is a real lure to unsophisticated developers.

THE THREE LEVELS OF OVERBUILDING

Overbuilding has an impact at three levels: local, regional, and national. Lets begin by exploring overbuilding at the local level since it has the greatest impact on your site.

LOCAL OVERBUILDING IMPACTS

The diagram shows a simple hypothetical market that is in balance, i.e. no excess supply or demand. Pricing is relatively consistent among the facilities and there are no major concessions being offered to prospective tenants. The dotted line represents a new player coming into the market. As you can see there are three facilities that will be impacted INITIALLY by the new project. Given this new imbalance in the market, let's take a look at what rational owners would do to protect their interests.

First, the new project owner needs to get some customers. Initially it would be good business for him to offer some significant concessions or to lower rents to get the project filled as quickly as possible. If his project has a superior location or better curb appeal than his competition, his concessions may end-up being insignificant. However, if all the projects are equal, or the new project does not have the curb appeal, then the concessions will have to be larger to create the necessary difference in perceived value to get those new clients.

The amount of concessions that a new competitor offers will also depend on the reaction of the other existing competitors. If they meet his new level of rental concessions, he may feel it necessary to increase the concessions to continue creating an incentive for the new customer. Unfortunately, if the new owner does not have experience in setting rates there is a chance that he will over-react to a slow lease up and drop effective rates too quickly, thus reducing the rental rates to levels well below where a new market equilibrium could have been established. In that situation it takes a very long time to rebuild the previous pricing structure and the Banker starts to panic. BE AWARE! The new competitor cannot simply be satisfied with Getting his share of the new business. Since he has to fill an empty project, he must find other new ways as well, to compete.

The best case scenario is to never have any new competitors. However, having a smart, experienced competitor is the next best thing. We are beginning to see well-capitalized, major developers competing vigorously on price in new locations because they believe that getting market share quickly is very important and they can absorb the start up losses.

There can be a significant Domino effect of rate reductions or concessions for facilities that border the new project. This effect creates the perception that a whole market within a 3 to 5 mile radius of the site is overbuilt by addition of that one new project.

Now, we should take a look at what happens to the existing owners and their reactions to this disruption in the market. Obviously, their client base changes each month and with each move-out, comes the need for a move in Usually, a current tenant won't move out to save a few dollars per month. However, when the annual turnover rate is considered, maintaining rates at above the market is not a long-term solution. The existing owners should also look for ways to make their project more competitive: a general sprucing up, new signage, increased security, and changing the Yellow Pages ad.

REGIONAL AND NATIONAL IMPACTS

Generally speaking, when overbuilding occurs it happens over a broad area of a metropolitan area. There are some positive aspects to this general level of overbuilding in that the word eventually gets around. Local banks stop lending and the developers are less enthusiastic about starting new projects. This takes some time to happen, the banks have to watch a problem develop with one of their loans and the developers have to hear a couple of horror stories. The bad news is that for financing and the selling of facilities, the market almost shuts down. Not only do local banks pull out, national permanent lenders also begin to significantly tighten their belts. Since rents may be down with vacancies up, the resulting sales prices and returns are lower for potential sellers. More importantly, the general enthusiasm will be out of the market and fewer buyers will be interested in buying self-storage facilities.

Since the last period of overbuilding, Wall Street has gotten involved in the business in a big way. First, the REITs have been financed with proceeds from stock sales to Wall Street investors. These investors, as we all know, are notoriously fickle and if the investments don't show growth or have a down period, the investors are no longer interested. However, the more important part of the Wall Street formula may be the impact it has on the Commercial Mortgage Backed Securities (i.e. the conduits).

In short, these are securities sold on Wall Street that are backed by commercial mortgages of all kinds of real estate. Self-storage loans are packaged in these securities and thus provide the funds for financing facilities. In the event that self-storage got a national reputation for being overbuilt, it is possible that the packagers of the loans would drop self-storage lending. Underwriters won't take the risk of continuing to invest in a market that's going down. Next month we will talk about which markets are currently under stress, how to tell if your market is overbuilt and what you can do about the situation.