Navigating Economic Cycles in Self-Storage

Some people think about the current administration, what's going on with tariffs. people are thinking about the fed rate environment. they have a meeting today, you mentioned at two o'clock. So there's, how the interest rates will play out, how inflation will play out over time. some folks have mentioned, insurance premiums are going up. There's just a lot of interesting dynamics in the real estate world today.

But I wanted to talk to you about this because you guys at AAA Storage have been doing this for a very long time, many decades now. You've weathered through some financial crises and downturns Given all of the dynamics in today's market, you are still very hopeful, optimistic that focusing on the fundamentals is still gonna ride through this wave, and that self-storage is still a very good investment to have in your portfolio.

And so what I wanted to ask you today is given your wisdom and experience. what was it like going through, let's say, the 2008 financial crisis or going through covid or even before, you know, there's dot com recession, then there's the 87 crash, and you know, there's lots of different periods in history that have been kind of dicey over the last few decades. You've weathered them, and so what was that like?

And then we'll kind of end the show on what would you recommend investors think about going forward in the event of a downturn or recession or something like that?

But you also mentioned the.com crash, you know, in the late eighties, early nineties. And, so I wanna start out by pointing out that as an asset class, self-storage and pretty much all of real estate, but particularly self storage, is not correlated to the public markets. One of the ways people can invest in self storage today, is through the five publicly traded REITs that are out there. and it's a, it's a good way to invest. I wouldn't say, you know, don't consider it.

And one of the reasons people love it is because they have the liquidity that's provided by the public markets. If I want to get out of my investment in self storage, if I own public storage, shares in their reit, I can sell 'em on the market, and I've got my cash in five days. The trade off for that is that they're very correlated to the public markets. I'll bet I haven't looked, but I'll bet.

If you went and looked at the stock price of those five REITs over the last two weeks, you'd see that they've declined. I wouldn't say significantly, but they've, they have declined. They have lost value. For no other reason than the general market was going down and people decided it was time to sell stocks.

And so there's a double-edged sword there in any publicly traded vehicle, which is, you do have the liquidity, which real estate typically doesn't offer, but you also then are directly correlated at some level to the public markets, which I think is one of the advantages of investing in alternative assets is that you get away from that correlation.

it's a reason why I strongly believe, like I've said multiple times on our conversations, that, you know, most high net worth investors should have an allocation to alternative investments and particularly real estate in their portfolio. So just to sort of open and comment, but you mentioned. 2008 and Covid, which was 2020, basically late 19. really 20 and 21. 2008 was a very interesting time because it was a recession in the real estate world.

it was not just an economic event that, was broad based. it was broad based, but it was very specifically a recession in the real estate world. There are two components, two market dynamics that will affect self storage. the first is the consumer side of the equation. the second piece of that is the transactional side or the trading side of that, the buying and selling of properties or the development of properties.

And they're really different and they're affected differently by different things. So during the oh 8, 0 9 timeframe, people. Lost value in their 401k because the market crashed. their homes became worth less than, you know, than maybe what they owed on 'em, or they dropped in value. but a lot of the activity that required self storage by the consumer didn't change at all.

nobody could borrow money. the banks weren't lending money, and so what you saw is that you couldn't sell a property at anything close to a value that made sense or what it was, what you knew it was intrinsically worth. we actually sliced and diced our portfolio. It's in our presentation for the fund, and looked at three different time periods and one of them was the 2008 to 2011 timeframe.

And what you see for projects that were, sort of maturing in that timeframe is on average, we held them longer. Because we waited out that market where there weren't enough buyers. The values really weren't there, cap rates were elevated. what happened for our investors during that period was that their capital was tied up a little bit longer. That's never what we want. our average project multiple in the other timeframe, so pre 2008 and 2011.

To today, our average equity multiple across the whole portfolio is about three times equity, is what we look for in terms of return from a project. We held the projects in that 2008 12 timeframe longer. So average whole time across the portfolio, little bit under four years average, whole time in that timeframe that we're talking about, the oh eight recession crash, whatever you wanna refer to it as. Extended to multiples of that as much as 8, 9, 10 years on average.

But we returned 4.2 times the equity to those investors so longer, whole period, bigger equity, multiple time valued returns were depressed a little bit because of the time the properties were held. So our average return across the entire portfolio that we've sold is about 20%. Returns on those deals were in the 14, 15 range because of time, but we actually returned more cash to the investors. So, that's what the oh eight sort of to 12 2013 timeframe looked like for us.

If you compare that to Covid, COVID was an absolute, super Bowl event for self storage.

They were having to clean out bedrooms to create offices so they could work from home where they gonna put that furniture? So it went into a self storage facility They were bored at home and had nothing to do, and they were cleaning out their garage and their attic and you know, and had all this stuff that they needed to put somewhere. so occupancy soared in the self-storage industry, and because of that, the equity side of the equation began to chase good quality, well located facilities.

It's one of the few times it was there because of the popularity, the product and sort of the professionalization and institutionalization of stories that we've talked about on another episode where you had larger equity players, the big REITs and everybody else sort of beginning to emerge. but there, there's not been many periods in storage. Where you can sell a property before you get it stabilized or leased up for full value.

during that period in the pandemic and then coming outta the pandemic, we couldn't get a project stabilized. We'd get to 60% occupied and somebody would offer us full value as if it were fully occupied. and we were selling. That's why our, our average hold time, since 2000 eleven's been three years. that's a little bit unrealistic. And today that I don't think that dynamic exists, and we don't forecast that and don't plan on that in terms of how we project returns today.

the fact of the matter is every property we've sold since, the average whole time of, for a property, from the time we started construction to the time we sold it was three years. and the Covid Pandemic created a lot of that. Because the product was performing so incredibly well and there was new equity coming into the market that was, you know, looking for good self storage. And that created a perfect storm.

cap rates for self storage, track multifamily, about 50 basis points behind multifamily, Cap rates got down into high threes, low fours in that same timeframe for much the same reason. And we saw cell storage cap rates in the low fours, to mid fours, where today they're high fives to low sixes. So a hundred basis points swing during that period of time coming outta the pandemic. So a lot of detail, maybe too much, but they were two very different.

The other thing I'll point out, 'cause we're talking about challenging economic cycles. So it's not, Self-storage has the lowest default rate of any type of real estate on the planet. in terms of, I think it's, I, I, I, whatever I say, I'll be wrong. It's 1 or 2%. and so from a senior lender standpoint, a bank standpoint, historically nothing has created fewer problems. For the banks in good times and bad than self-storage

And everybody gave him crap because he had a lot of puts out there and stuff like that. I just think the hell is coming. You know, things, things can be really bad and you're like, no man. It was actually great. You know, it was different.

The dynamic was different, but during these times it actually because of having capital in self storage, because of the way the asset is structured and the way the deals are structured, it actually can be an amazing thing because of those dynamics, like through covid, people putting their stuff in self storage, having historically low. Default rates and things like that. I mean, it's just seems counterintuitive, the way that you're describing it, it's so insightful that, like,

If people don't have money, then, you know, but typically when you see a recessionary environment, and maybe employers are cutting back and people are losing their job again, what do they do? That's the point. They say, well, you know what? I didn't wanna live in New York anyway. So I'm gonna move to Texas, or I'm gonna move to North Carolina, or I'm gonna move to Tennessee. And when they move, they need self storage often. so it, it, it is a little bit counterintuitive.

Storage is not completely insulated, you know, from every bad thing that can happen. But the other thing that's interesting about self storage is generally what will happen, the, the demand dynamics are consistent enough. They ebb and flow. Sometimes they're higher than others.

But they're consistent enough that what happens to a self storage deal in a bad economy that's directly affecting its customers, is that it simply takes longer to lease it up if you're well capitalized and you know how to manage it Here, stop me if we don't have time today, but, one of the things a lot of people don't understand about self storage. Is it, the lease up process is wholly different than any other kind of real estate.

If you're gonna build a grocery anchored shopping center, the bank's not gonna let you do one thing until you have a signed lease with Kroger or, or, you know, whoever, they'll, they'll let you take a, a spec risk on the shop space, but you're gonna have an anchor tenant or, or they're not gonna, they're not gonna fund the loan. The, the same thing happens with office buildings. You're not gonna break ground on an office building until you're 50% leased and most industrial buildings are similar.

There's not a lot of speculation. when we build a self storage facility and get it finished and get a certificate occupancy, we have not one customer, not one lease sign. 'cause nobody's gonna, we might in the last week or two have a reservation or two that represents $200 a month in revenue. Whoop. I mean, it's not gonna change the game it takes. It takes two to three years to lease up a self storage facility. until it's producing cash flow and that kind of thing. So you have to plan for that.

You have to have working capital as part of the equity capital that you've raised. The banks will often give us an interest reserve to help pay the interest only payments during the construction period and for very beginning of lease up. But you've got a facility that has operating costs and has debt service payments that have to be made, and you have to plan for that. when we pro perform a project, we try to, we, we have a play.

We've run, I've gone through it before, but, it takes us about four and a half years to build two phases of a project and get that all to stabilization. And it's, one of the other benefits. the other benefit that we have is that we are financially strong. So if we have a project that's a little bit under capitalized, it gets extended because the market slowed down. And so the lease up wasn't as fast as we wanted it to be. We have the ability to support that project, and loan it money.

instead of diluting the investors or having them have to put in more capital, to get that project to buy out a little more time, another year to get to lease up. But my whole point of all that was it's not a matter of whether it's gonna lease up, it's a matter of when it's gonna lease up. And you, you don't see timeframes get extended from three or four years to eight or nine years I've never seen that. You might see a project that really was budgeted to be leased up in three to four years.

That takes five years or four and a half years. But so typically that's the biggest difference and that's why you don't see the level of defaults on real estate loans and storage that you see in other types of property. So.

Thinking about, you know, heading into what seems to be uncertain times at least what you would read about in the headlines. Now, of course, economists and investors have been saying there's been a recession for the last three years, you know, and we're still not quite there yet. Maybe some correction territory, but not quite a recession. is there anything like that, that you're, you're kind of paying attention to now?

What it did was slow people's decision making to buy a new home and move and moving is 25% of demand in self storage. So the drop in activity and home sales has had a very noticeable effect on self-storage. you combine that with the fact, if you remember when I said sort of storage exploded during covid. The amount of new development that started. And remember, it can take two years to get a piece of land ready to build on.

So when somebody says, I'm gonna build a self storage facility, that means you'll probably see something come out of the ground in a year to a year and a half and maybe be ready to lease it the two year mark. So 20, late 20 really 21 development exploded. So you've got a lot of markets that have gotten a little overbuilt. And the result of that, particularly for the big REITs and the big private equity players, is they value occupancy over rate.

And they've gotten very sophisticated using demand-based pricing al algorithms, and so they have forced rates down on a national basis. There's been a month over month rate decrease in the self-storage industry for 28 months in a row.

So you've had a drop in demand and you've had a little bit of overbuilding in some markets, which all of which has resulted in rates coming down. And value of property is a function of its income. So if rates are coming down, then theoretically values are coming down. unless cap rates. Are also coming down. But what we bet on in 2023 was that the higher interest rates have forced the banks to look at cash flow coverages versus loan to cost ratios. And it has constrained a lot of projects.

And so there has been a marked decline in the amount of new development. While the demand dynamics have stayed essentially the same the moving piece has taken away some of the demand, but that demand is just getting pinned up. It will explode again when rates come down so that demand hasn't gone away. It's just been delayed. what we're doing is we're developing into this market when other people are afraid to develop or can't develop on the assumption that.

Three years down the road, four years down the road, when our facilities are leased up and ready to sell, there'll be a shortage of new supply in the market, which will help a little bit on the operational side, but will really make our properties more valuable on the capital side of the equation when there are still buyers out there that are looking for good facilities. And there've been fewer new facilities developed in the last three or four years.

And you know, you're seeing that in multifamily right now. Multifamily got overbuilt coming out of Covid. It sort of lost its darling status in the last year or two. Development really slowed, and now you're starting to see the bottom of that market and demand start, I mean, demand consistent, but new development starting to come back a little bit and George will have the same cycle.

And all of a sudden, that sponsor or that investor or that developer. can't make the deal make sense. And so they own the land or, or maybe they had the land under a contract and they walk away. there's a lot. Right now in every market that we are building in the pipeline of new properties has dropped to below 3% of the current inventory. which tells you that development is contracting. And there's not gonna be as many, nearly as many new deliveries, two and three years down the road.

national average is about 3.1% of current inventory. but the markets we're in little, even a little bit better than that. And 3.1 is a good number on a relative basis. tens of percentage points in that metric make a difference. but you know, probably, in the healthy markets you're probably looking at 4% pipeline at 4% of, of, current inventory. So.

If you're talking to an investor today, given what you have experienced in the past and the decades of doing this many different cycles, and looking ahead the next year or two, what advice would you give them or what wisdom would you encourage them with?

We've got a facility in Hillside, Texas where Sam Houston State University's located, and our occupancy explodes in April every year. Because all the kids are getting outta school and getting the stuff outta their apartment and you know, store it till they come back in September.

So there's a little bit of severe seasonality there during the summer, but mostly it's millennials and Gen Xs and they're all hitting household formation age, which is when they start to hit all the life events that drive the uses of storage. So if you look at all the demographic data and you look at the fact that today in America, 10% of people in our country. are using or will use self storage in the next six months.

And then so the developers stop building and four years later, you can't buy one. And they're so expensive, they blow your mind. And it's just this rollercoaster. self storage is not quite as volatile as condos in Myrtle Beach, but there's an element of that to it.

We're seeing a season right now where, because of the extraordinary performance during Covid and the institutionalization of the industry with lots of private capital, big dollars coming into the industry where there are markets that are getting overbuilt. and so where you used to could throw a dart at the map. And wherever it landed, build a self storage facility and you'd be just fine. You better cut with a little sharper instrument today.

and make sure it's why we focus on, we're not in the metro markets. We're not in downtown Austin. We're in the bedroom communities. We call 'em city skirt. Markets that support Austin, we're the suburbs where people live and they're driving into Tesla or, ut or wherever. same thing in Charlotte, North Carolina. We've got a piece of property that'll be in our next fund in Gastonia, which is a secondary market to Charlotte, but really driven by the growth and the dynamics of the Charlotte market.

So we sort of insulate ourselves a little bit from some of the boom and bust. We can buy land cheaper, it's easier to get entitlements. the whole process is a little easier. there are markets that on a market basis show net declines in rates, over the last number of months. And that's partly because of a drop in demand related to moving. And partly because those markets have gotten a little overbuilt, but they recover pretty quickly in storage.

but if you follow different things and I follow all the segments in real estate and try to keep up with the data, one of the largest, operators of those type of car washes just filed for bankruptcy, got overbuilt. They over levered it, which is the private equity guys are famous for. you know, they love to borrow money 'cause it drives extraordinary returns, but it also can come and bite you if things don't go as planned. So, but yeah, that industry's starting. It's still a good place to be.

I've got two very close friends that, are successful wealthy individuals and they develop car washes on their own. and they're still developing, but you just gotta be in the right market.

In a small market that hasn't shown any, you know, significant growth, historically, you have to be a little more careful 'cause you can get caught. but for example, we're building in Georgetown, Texas, which has been on a percentage basis. one of the fastest growing towns in all of America. It's a suburb of Austin. and we've got two facilities there and we've also got an industrial flex facility there that have done fantastic.

because that suburb, it's supported by Austin, you're not dependent on Georgetown on a standalone basis, its growth is being driven by Austin. Now you can go to, Clinton, North Carolina, in southeastern North Carolina. Clinton's been, if you could go back in time 20 years ago, Clinton looks today just like it did 20 years ago. Great place to live, great quality of life, great place to Raise a family. But there's many people moving out as there are moving in and there's just not a lot of growth.

And you know, that's a market where if the demand's there, you're good. If the demand's not there, you can't manufacture it. So you kind of get caught. So anyway.