The Surprising Performance of Self-Storage

Over the past few years, the stock market has experienced extreme volatility. People who would otherwise invest in alternative asset classes, like multifamily real estate, have encountered increasingly frothy conditions. Many of those investors are instead turning to self-storage as a way of stabilizing their portfolios while maximizing their income and growing their wealth.

What is Self-Storage?

Self-storage facilities are generally considered an industrial property type in which a warehouse-style building is subdivided into smaller storage units. Self-storage facilities have become increasingly advanced in recent years. Historically, these were basic structures where individual units had a door, lock and key. Today, self-storage facilities can be high-tech with advanced climate control, lighting and security systems that offer a range of ancillary amenities for tenants. For example, modern self-storage facilities will often have a U-Haul rental facility on-site to make transporting goods to and from the facility easier.

It wasn't that long ago that self-storage was considered a small real estate niche. Today, as demand for self-storage grows, it has attracted the attention of prominent institutional investors. The self-storage industry has become more organized and in turn, offers tremendous upside potential for investors looking for portfolio diversification.

What's Driving Demand for Self-Storage?

The self-storage industry has traditionally been disaggregated. Owners tended to have one, maybe two or three properties and were managed as family businesses. Yet, with self-storage demand on the rise, more sophisticated investors are paying close attention. Increasingly, institutional investors, REITs and large family offices are adding self-storage to their portfolios. Here's a look at what's driving demand for self-storage, and in turn, driving investors to the sector with record speed.

Low Volatility

Compared to other asset classes, self-storage has very low volatility. Its values do not ebb and flow like the values of stocks or bonds. Moreover, because units are rented on a short-term basis, it makes it easy for an owner to evict a tenant for nonpayment of rent. That unit can quickly be re-leased at market rates which helps to ensure consistent cash flow.

Low Vacancy Rates

Properly managed self-storage facilities tend to have low vacancy rates. The demand drivers featured here (including the lack of self-storage new construction) has pushed vacancy rates to all-time lows. As evidence, real estate brokerage firm Marcus & Millichap reports that the national self-storage vacancy rate reached a multidecade low of 5.5% last year.

Strong Rent Growth

The self-storage industry is one of the hottest real estate asset classes. With rent growth increasing by an average of 7 to 8 percent per year, only multifamily has had higher increases. There is some debate as to whether this rent growth is sustainable. Many industry experts anticipate that annualized rent growth will slow to 3 to 4 percent in the coming years, given rising interest rates and general economic uncertainty.

Limited New Construction

Interestingly, the pipeline is robust for planned and proposed self-storage units. However, for a variety of reasons, actual completion rates remain low. Last year, only 175,000 new self-storage units came to market. This represents the lowest rate of new construction in at least eight years.

Several factors contribute to the lack of new self-storage construction.

One of the reasons pertains to supply chain disruptions. Many builders simply cannot get the materials needed to construct these facilities - and if they can, the increased costs of those materials often results in projects being put on hold. Meanwhile, land that might otherwise be used for self-storage often faces competing pressure from multifamily, retail and other property types considered more valuable. This is particularly true in land-constrained environments, like urban and suburban areas, where highly visible sites are considered to have a higher and better use than self-storage.

The lack of new self-storage construction is boosting both rent gains and occupancy rates, something that investors are paying close attention to.

Demographic Trends

There are two primary demographic trends that support demand for self-storage units. The first is that Baby Boomers are retiring, moving and often downsizing. They will frequently use self-storage facilities to house their goods temporarily (during those moves) or permanently (for items they aren't ready to part with but that can't fit in their smaller homes). Many of the items Boomers are saving are intended to be passed down to their children, those in the Millennial and Gen Z groups, who are now (or on the cusp of) buying homes.

To that point, the second demographic trend to watch is new household formations. Generation Z, which makes up more than 20% of the U.S. population, is just starting to form new households. The shift to remote work is expected to accelerate Gen Z'ers relocation to different cities—especially low-cost areas—and these moves create demand for storage units.

Strong Labor Market

The U.S. unemployment remains at a staggeringly low 3.7%. It continues to be a job-seeker's market. Many people are taking advantage of the market conditions by changing jobs. These jobs may be in new geographies (thereby forcing relocations) or may be for higher salaries. In either case, this creates demand for self-storage units.

Similarly, in a strong economy there are more new business formations. New business formations, like new household formations, generally translates into increased demand for self-storage.

Growth of E-Commerce

E-commerce was already on the rise pre-pandemic but COVID certainly accelerated its growth. With people concerned about shopping in brick-and-mortar stores, they had no choice but to shop online. This forced retailers to adapt. In order to survive the pandemic, retailers shifted more (or all) of their sales online.

The rapid rise of e-commerce has created demand for micro-fulfillment centers. Retailers are increasingly using self-storage facilities like small warehouses for their products. Startup companies are utilizing a similar approach, drawn by the short-term leases and flexibility that self-storage facilities provide.

Supply Chain Disruptions

Supply chain disruptions have impacted self-storage in a few ways. The first pertains to the lack of new construction as discussed above. Developers either cannot get the materials, or cannot afford the cost of materials, needed to build a self-storage facility that pencils out economically. In turn, this has put pressure on existing self-storage facilities with rents and occupancy rates on the rise.

Meanwhile, builders of all kinds (not just self-storage) are increasingly utilizing self-storage facilities to stockpile materials, appliances and other goods needed for their projects. Doing so helps to mitigate the impact of the supply chain disruptions and reduces the lead time for critically important items.

Likewise, many retailers are using self-storage facilities to stockpile inventory. Demand for clothing and home goods remains especially high, so retailers are facing pressure to keep these items in stock. Rent appreciation at more traditional warehouses and distribution facilities has caused people to rent self-storage facilities for these purposes instead.

Cap Rates for Self-Storage

Cap rates, or the "capitalization rate", is a metric that many real estate investors use to assess property value. Cap rates and values tend to have an inverse relationship: the lower the cap rate, the higher the value. Cap rates are calculated by dividing the net operating income (NOI) by the purchase price.

Pre-pandemic, self-storage cap rates were around 7-9%. This is marginally higher than the cap rates for multifamily, office and other asset classes. However, rent growth and lower vacancy rates have compressed self-storage cap rates. Today, cap rates are in the mid-5% range or lower, depending on the market.

Cap rates are continued to remain low given the pent-up demand from institutional investors, REITs and other well-capitalized buyers willing to pay a premium to expand their market reach.

Why Self-Storage is Recession Resilient

Self-storage appeals to investors because it performs well during economic boom times as well as downturns. During a strong economy, the demand drivers noted above all still pertain. However, during a recession, self-storage continues to perform well.

During a recession, many individuals decide to lower their housing costs by downsizing. The couple living in a 4,000 square foot home moves to a 2,000 square foot home. The couple living in a 2,000 square foot home moves to an apartment. All of these moves create demand for self-storage.

In particularly bad economic times, people may even face foreclosure. Those people often move to apartments or move in with friends and family. In either case, they tend to have less space for their personal belongings and rent self-storage units rather than selling their things. Their need for self-storage is typically sustained as they re-build their credit and work towards purchasing their own homes once again.

Self-storage facilities also have "sticky" tenants, even during a downturn. Whereas someone might not be willing to absorb a 6% increase to their apartment rent, a self-storage tenant paying $100 per month might oblige. People would generally rather spend $6 per month more versus having to rent a truck to move all of their belongings to a different facility. This allows owners to continue increasing rents even when the economy dips.

What are the Best Markets for Self-Storage

The Sunbelt remains one of the strongest markets for self-storage. This is because people continue to move to the Sunbelt states, which tend to have lower costs of living and enviable climates. Any moves tend to create demand for self-storage. Vast population gains in the Sunbelt are expected to continue, and the self-storage market there is not yet saturated.

However, it may come as a surprise to find that self-storage is also performing exceptionally well in the Midwest as well. Anecdotally, this could be because institutional investors have been more laser-focused on the Sunbelt region whereas self-storage facilities in the Midwest are still largely owned and operated as family businesses. This creates significant opportunity for investors willing to buy there.

This shows that self-storage performance gains are rather ubiquitous: as long as there is movement of some kind (divorce, death, dislocation or disaster - the four "D's" of self-storage), there will be demand for these properties.

The Outlook for Self-Storage

Self-storage is expected to face some headwinds in the short-term. Rent growth is anticipated to slow and cap rates may begin to rise. However, the mid- to long-term outlook for self-storage remains exceptionally strong given the demographic trends noted above.

What's more, the sector offers tremendous upside potential for investors. Many self-storage facilities are owned by long-term, mom and pop operators who are largely hands-off operators. A lot of these owners are on the brink of retirement and rather than modernizing their facilities, they are opting to sell. For owners who are willing to put in the work, the value-add potential of self-storage facilities remains high. Owners can increase the income, increase the property value, and then refinance or sell - especially with so many institutional investors looking to add self-storage to their portfolios.

Any investor who is looking to hedge against uncertainty will want to take a serious look at the self-storage industry. Although consumer activity is still trending upward, rising inflation is generating some concern in the near-term economic outlook. The counter-cyclical demand factors - including household contraction and forced relocations - make self-storage attractive even during downturns. Moreover, monthly leases allow self-storage operators to adjust to changing market conditions in real-time, thereby maximizing the asset's value.

If you're interested in investing in self-storage, don't wait. The surprising truth about self-storage is that there is growing competition for these assets, particularly among well-heeled institutional investors, pension funds and REITs. Where others see mom-and-pop properties, they see vast opportunity.

Contact us to start investing in self-storage today.