The Changing of the Seasons...and the Real Estate Market?

In the last issue of the Market Monitor I described what I believe to be an improved real estate investment market for self storage properties. You might recall that we are seeing a substantial bifurcation in the market, where large properties and portfolios are demanding a premium to smaller, one-off self storage properties. There are some very good opportunities that have been popping up over the last 6 months but I am here to tell you that these favorable conditions won't last.

We are slowly starting to see buyers and sellers come together again on what they both agree is a fair deal, due to a little give and take on both sides. However, most of the giving has been on the buyer's side, as we are seeing buyer confidence return to almost all-time highs. This is due in part to the performance of the self storage sector over the last 12 to 18 months. I say this with one caveat; projects that were built in secondary locations or in overbuilt markets during the late boom of 2006-2007 have not seen the same rebound in value. It will take many years for these projects to perform if they are ever able to achieve the values that were once contemplated.

Prices of self storage facilities (per dollar of net operating income) hit an absolute all time high in mid-2007. At that time, buyers would accept the validity of just about any projection (proforma) and would be able to finance the project to the maximum level. This has all changed and buyers today are disciplined in their underwriting, and more importantly, the banks are even more disciplined when considering financing new acquisitions. The reality is that many of the transactions today have underlying factors that are allowing both the buyers and sellers to achieve their investment goals and these underlying factors have very little to do with the performance of the property. The two major fundamental factors that are motivating buyers and sellers today are capital gains tax and interest rate risk.

The 10 year T-Bill bouncing between 2.50% and 2.75% has enabled banks to loan money to their clients at close to historically low levels, and it has in turn allowed buyers to achieve a rate of return on new acquisitions that are in line with their expectations and perceived risk of the investment. Sellers today are still talking about the values of 2007; most know though that it was simply a sign of the times and they are now choosing to focus on their self storage investment and make decisions that will allow them to achieve the highest internal rate of return (IRR) possible. Sellers today must consider the issue of capital gains tax and the possibility that they will increase in the coming years. I am neither an accountant nor do I have a crystal ball, but if real estate owners are faced with a 5% to 10% increase in capital gains tax it will adversely affect the investment's IRR. Depending on the increase in capital gains tax, it will reduce the after-tax net proceeds, and an owner may receive 5% to 10% percent less. Therefore, every $100,000 in after-tax dollars an owner may now receive under the current tax structure will be reduced by $5,000 to $10,000, leading many owners to consider selling before these changes are put into place.

This all leads me to believe that this market has reached equilibrium at a level that is about 12 to 15 percent lower than the all time highs of 2007. Historically, this places values of self storage properties at the high end of the spectrum. These high values, compounded by the uncertainty of the capital gains tax and interest rate risk, have led may of the most sophisticated owners to do what they once considered unthinkable and sell. For example, if the financing market becomes either less liquid or more expensive, the price of a facility will fall. The math is simple, if you pay the lender more, you cannot pay the seller more and if you put in a larger investment, you need a larger return. Additionally, the current concerns about capital gains tax have caused many property owners to do the math and consider selling so that Uncle Sam doesn't get more then his share. Thus, if you are planning on selling sometime in the not too distant future, you may want to consider doing the math, talking with your accountant and accelerating the process.

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