While Wall Street continues to punish several property sectors due to a stubbornly persistent credit crunch and fears of an eroding economy, the self-storage sector is proving to be quite resilient.

Total returns for self-storage REITs were up 17% for the year through July 22, according to the National Association of Real Estate Investment Trusts, the best performer of any commercial real estate sector. Not even apartment REITs, which are benefiting from a housing slump and foreclosure crisis, could top that figure. Total returns for apartment REITs jumped 16% during the same period.

What accounts for the double-digit returns in self-storage this year, particularly after a rather disappointing run in 2007 when returns fell 25% for the year? Despite fears about the housing market, demand for self-storage has remained robust.

Measured in rentable square feet per person, demand rose to an average of 6.12 sq. ft. at the end of 2007, up from 5.7 sq. ft. in 2005, according to Chris Sonne, managing director of Cushman & Wakefield's self-storage industry group in Irvine, Calif. Sonne estimates that over the past 50 years, more than two self-storage facilities have been built every day in the U.S. “That's a pace greater than McDonald's,” he says.

Funds from operations (FFO), a common metric used to measure REIT performance, reflect the health of the asset class. FFO was up more than 11% for all four self-storage REITs in the fourth quarter. Thus started the rally that has led to the sector's current healthy performance, according to Kenneth Woolley, CEO of Extra Space Storage (NYSE: EXR).

Not so fast

But recent past performance is not necessarily a true indicator of what's to come. And the self-storage industry faces its share of challenges. Construction loans for self-storage facilities are in short supply and cap rates have yet to meet both buyer and seller expectations.

“We have had a slight slowing of our revenue growth from the first to the second quarter,” says Woolley. A year ago, Extra Space's revenues were growing in the 4% to 5% range. Now growth has slowed to 2.5% to 3%.

“I think we are being more affected in a negative sense by high gas prices than the housing crisis. All of our customers have to come to our facilities in vehicles, and the high gas prices reduce people's desire to move. That's because things are more expensive to move,” says Woolley. Gas prices at the pump nationwide rose to $4.04 at the end of June, up from just $3.04 per gallon a year ago, according to Property & Portfolio Research.

The full impact of the housing downturn is likely to be better gauged when the REITs report their second- and third-quarter earnings, according to Michael Mueller, a JP Morgan Securities REIT analyst and executive vice president. Second- and third-quarter earnings are tied to the spring and summer months when there is more moving activity.

“Winter months are about minimizing your downside,” Mueller says. “Summer months are about maximizing your upside, so the full extent of it is yet to be seen.” Even then, the analyst expects the sector to perform better than other property types as a defensive play against recessionary conditions.

Liquidity 101

Against this economic backdrop, investors have begun to make new use of an old skill — discipline. “Everybody is looking at cash flow and saying, ‘What's the trailing 12-month net operating income? That's what I'm going to base my cap rate on, what I'm going to pay for,’” explains Sonne of Cushman & Wakefield. Over the past few years, investors were more likely to look to future prospects, banking on anticipated cash flow.

From 2003 through the end of 2007, a historic period marked by an abundance of capital at extremely low interest rates, cap rates for self-storage properties dropped from an average of 9.5% to 7.2%, according to Cushman & Wakefield.

The cheap debt enabled buyers to bid up prices to unprecedented levels. But during the past nine months, the trend has reversed, and now cap rates have climbed some 50 basis points to reach roughly 7.5% in July.

“It's not because the net operating income characteristics have changed,” Sonne maintains. “It's totally been a function of the capital markets where interest rates have risen, causing cap rates to rise.”

Self-storage transaction activity has also slowed though, according to industry experts. “The anecdotal story to that is that in Arizona in '06 and '07, there was a sale transaction every month of a self-storage facility,” Sonne recalls. “And in '08, year-to-date, there's only been one sale.”

Banks have also come to embrace the new-found religion of discipline, though it may sound a little mandatory given that they're already faced with billions of dollars in write-downs. “There are banks that are lending on self-storage construction projects but the lending criterion is very strict,” says Sonne.

In short, lenders are requiring borrowers to provide more equity today. Loan-to-values have fallen from 80% to a range of 65% to 70%. The length of time that it takes to lease up a facility has also increased over the same period of time to up to 36 months, which means banks require higher reserves, according to Steve Hryszo, vice president and national director for self-storage with CB Richard Ellis in Cleveland.

One reason banks may be more fastidious is that it takes 30 months to reach stabilization, widely believed to be 85% occupancy. Building the facility takes only about six months, leaving the developer to service the debt for the remaining 24 months. “As a result, if you're not cash flowing, you can get behind on that loan pretty quick,” says Sonne. “So the reserves are higher to service the debt until the property is cash-flowing.”

Bulking up on assets

While Extra Space has a preference for development, which can generate higher returns, the REIT builds only 12 to 15 facilities per year at a cost of roughly $150 million. In order to accelerate growth, the company acquires existing properties.

Last year, Extra Space snapped up $380 million worth of self-storage facilities, and plans to spend another $300 million in 2008.

Public Storage (NYSE: PSA), a REIT based in Glendale, Calif., also has turned toward acquisitions for growth over the last few years, says Clemente Teng, the company's vice president for investor relations. The REIT acquired Shurgard Self Storage, another public REIT, in 2006 for about $5.5 billion, adding roughly 500 facilities in the U.S. and Europe.

“You can acquire, thus eliminating much of the drag associated with filling up new developments, but still generate some upside by raising occupancy and integrating the properties into your system,” says JP Morgan's Mueller.

REITs prefer to acquire rather than build because they don't have to contend with the entitlement process, including securing building permits and haggling with local governments, who see self- storage for what it doesn't offer — local employment or sales tax revenue.

In some parts of the Los Angeles area, local authorities have entirely removed self-storage from their zoning, which tends to create solid demand for existing facilities.

“That's one of the reasons Extra Space and some of the other storage companies are focusing their energies on owning and developing properties in the densely populated, higher-income places,” Woolley says.

Indeed, the housing market's troubles have had minimal business impact in areas of the country where there was little new construction during the housing boom, like the New York and New England regions. What did not go up need not come down, so home prices in those areas haven't suffered the fate of boom markets.

Meanwhile, rental activity has shifted downward in markets like Las Vegas and Phoenix, both of which hitched their stars to construction and are now weak. In Detroit, for example, Woolley attributes a 5% increase in demand partly to people leaving the city and storing their belongings.

Unlike hotels or retail, building and operating self-storage facilities is a fairly simple business model. “The storage itself is still generally a room of steel partitions, a steel door and a concrete floor,” says Woolley. “Ultimately, you're really selling air in a space.”

Despite bright prospects for self-storage, consumer confidence stands at a 28-year low based on the University of Michigan's consumer sentiment index released in early July. Decreased confidence lessens the odds that consumers, who make up two-thirds of the economy, will spend money.

A study by Merrill Lynch REIT analysts found that given a 12-month lag, there is as high as a 60% correlation between consumer sentiment and revenue growth in the self-storage asset class. The study also revealed a 70% correlation between occupancy and revenue growth 12 months later.

Ultimately it is likely to be the macro economic conditions, beyond the control of developers and investors, which will have the biggest impact on self-storage. “With cap rates rising, no one is clear about the direction of the market,” says Sonne. “Everybody is waiting on the sideline to see what happens.”

Poonkulali Thangavelu is senior associate editor.

Public Storage mines European potential

While self-storage is popular in the United States, where up to 10% of households use the structures, the idea of owning more personal property than you have space for and then paying to store it is still in its infancy overseas.

“If the European market were to build self-storage facilities based on the same population density as the U.S., there could be a need for approximately 34,000 facilities in Western Europe,” said John Reyes, senior vice president and chief financial officer of Public Storage (NYSE: PSA) during the company's fourth-quarter earnings conference call in March.

Considering that there are fewer than 1,500 self-storage facilities currently operating in Western Europe, the potential for growth is enormous. In Paris alone, where there are about 60 existing facilities, the population base could support as many as 1,200, according to Public Storage.

The REIT's European business is spread across Belgium, Denmark, France, Germany, the Netherlands, Sweden, and the United Kingdom.

In Europe, the company is realizing cap rates on sales transactions in the range of 6.5% to as high as 10%, depending on the market. With few property sales, however, it is difficult to pinpoint an accurate figure on returns, according to Clemente Teng, vice president for investor relations at Public Storage.

The REIT's strategy is to expand in markets where it already has facilities in order to build up scale for greater efficiency. But developing countries such as India and China, for the moment, remain untapped.

“We hate to be the first mover there because you have to pay a lot of tuition in order to be the first mover,” explains Teng. For that reason Public Storage acquired Shurgard Self Storage, also a REIT, in 2006 for $5.5 billion, adding roughly 500 facilities in the U.S. and Europe. “The advantage we had in the acquisition of Shurgard is that Shurgard spent a lot of time and money early on developing the facilities in Europe.”

Then last year, in an effort to raise cash to grow the European operations, Public Storage attempted to sell a 51% stake in Shurgard Europe through a public offering of shares in Europe. That plan fell through in June last year as the subprime crisis began to take hold.

The plan was revived in the first quarter of 2008, when Public Storage managed to sell the 51% stake in its Shurgard European operations to New York State Common Retirement Fund for $606 million.

“This transaction will enable us to continue our growth path and our business expansion,” stated Steven De Tollenaere, CEO of Shurgard Europe, when the deal closed in March. “In 2007, we expanded to 174 storage facilities all over Europe. We are now perfectly positioned with great shareholders and strong funding to accelerate our development program and undertake acquisitions, increasing product and brand awareness in Europe.”
— Poonkulali Thangavelu