This article originally appeared on REBUSINESS Online
Developers of self storage properties in major Texas cities are consciously putting the brakes on new construction as they wait for excess supply to be absorbed and for positive rent growth to return to the market.
The market has been moving in this direction for some time. While property owners have generally maintained occupancy rates that meet pro forma thresholds for profitability, rent growth has been and will likely remain stunted. Supply growth has led to competitors cannibalizing each other’s market shares.
In addition, ever-rising construction costs and a dwindling inventory of buildable sites are also governing the pace of new self storage development. While certain pockets of developable sites still exist here and there, lenders and equity providers have also taken note of the saturated landscape and are tightening their purse strings for self storage projects.
“With respect to major markets, there’s no question that the pipeline is thinning out, and for projects that haven’t yet started construction, probably half of those proposed won’t come to fruition during this cycle,” says Bill Brownfield, owner of Brownfield & Associates, the Houston-based branch of industry-tracking firm Argus Self-Storage. “Markets are largely stabilized in terms of occupancy. But rent concessions and discounts have not only carried over from last year, but accelerated in 2019.”
“The development pipeline for Texas as a whole has peaked and is slowing down,” adds Michael Johnson, broker at self-storage investment and brokerage firm Bellomy & Co. “This reflects the market’s awareness of slow revenue growth and the amount of new supply that has hit major markets.”
According to data from Marcus & Millichap, the average vacancy rate for self storage properties in Texas and Oklahoma slid by 30 basis points to 8.3 percent during the 12-month period ending December 31, 2018, the latest data available at the time of this writing. The average monthly rental rate fell by 5 percent to 96 cents per square foot during that period.
Data from self storage tracking platform Radius+ notes that the volume of new development in Dallas, as measured in net rentable square feet, is set to expand by 8.1 percent in 2019. Supply levels for 2019 in Houston and Austin are projected to increase by 4.3 percent and 12 percent, respectively.
The market will certainly turn the corner — it’s just a question of when. The fundamentals behind self storage remain strong in Texas, a major reason why roughly 10 percent of the national supply is located in the Lone Star State. And with firms displaying a clear understanding that the current development cycle has run its course, it’s mainly a question of seeing existing projects through with aggressive marketing campaigns, and beyond that, hunkering down until the cycle bottoms out.
Self storage is often referred to as a “three- to five-mile business,” meaning most of a facility’s customers live within that range of the property. In that sense, the question of when the industry will see a return to positive rent growth varies widely from one neighborhood to another.
“The question of when rents will hit rock bottom and turn the corner is still submarket-specific,” says Johnson. “In submarkets where there are multiple facilities in lease-up, it’s a race to the bottom in terms of rental rates. But there are also some submarkets with only one newly built facility that is absorbing demand and not having to discount rents as heavily.”
Sam Smalling is a development associate at The Jenkins Organization, a Houston-based developer and manager that recently opened an 850-unit facility in downtown Houston and an 800-unit property in Austin. In his view, in the urban cores of Houston and Austin, it’s getting harder to find sites that haven’t been scouted by competitors and to find submarkets lacking a strong self storage presence.
“The level of new development is very concerning; you can’t put down a new facility without someone already being there or coming in behind you,” says Smalling. “If a great site comes across our desk, we’ll still look at it, but for the most part we’re ramping down our new property searches considerably, and instead focusing on current developments that are coming on line.”
Smalling adds that in this hypercompetitive environment, the battle for rents and occupancy can sometimes be won or lost on the amenity front. Highlighting features like cleanliness, aesthetic appeal and proximity to customers’ daily travel routes can translate to significant advantages for an owner-operator.
“Competition is stiffer in some submarkets than others, and it’s largely a factor of whether your competitors are in lease-up,” says Smalling, who expects the major markets of Texas to take at least three years to absorb the existing supply and experience a return to positive rent growth. “But a good marketing campaign can mitigate some of those dips in occupancy and revenue.”
As with most sectors in commercial real estate, sustained employment and population growth will be the keys to the market’s rebound. Through the first half of 2019, Texas has added between 12,500 and 13,000 jobs per month, according to the Bureau of Labor Statistics.
And according to World Population Review, the state’s population has grown by more than 4 million people over the last decade, currently sitting at about 29 million and projected to grow by an additional 2 percent by year’s end.
“The good news for the Texas self storage industry is that we’re still adding jobs and people,” says Steve Mellon, managing director of JLL’s national self storage team. “So in my opinion, we should see rents turn the corner in a year or 18 months as more jobs create more housing, which creates more demand for storage.”
Mellon notes that the “rent rolldown” — an industry term for the gap between street rates quoted to new customers and in-place rents — has been shrinking in Texas as new supply has come on line. In a strong market, owners will push rents on existing customers, but the heightened level of competition has brought in-place rents much closer to the discounted levels being pitched to new occupants.
“Facilities are getting filled up, but just because your facility is fully occupied doesn’t mean you’re collecting all the dollars you should be,” says Mellon.
Despite the saturation of the market, which has hurt properties’ average operating incomes, self storage assets in Texas continue to receive strong interest from investors.
According to Marcus & Millichap, sales prices for Texas and Oklahoma facilities increased in 2018 for the ninth consecutive year, clocking in an average price of $77 per square foot. Average cap rates have stayed relatively flat for the last couple years, but remain about 100 basis points above the national average.
The strong investment demand is occurring in the face of rising property taxes and labor costs. According to Brownfield of Argus, these are the two biggest headwinds facing the industry with regard to operating costs.
It makes sense that these two line items would be tipping the scales on the costs sides of balance sheets. Property tax assessments are directly correlated to asset prices, which are a function of levels of investment demand. And with rising land and construction costs, developers are obligated to build larger facilities to make their numbers work. The larger the facility, the higher the operating costs.
“With property taxes, there’s a fair amount of unknown risk in terms of what direction some counties are going,” says Brownfield. “And with the economy boasting such a tight labor market, payroll costs are going up, even though this cost is typically lower in self storage than in other asset classes.”
The key factor among these inhibitors, Brownfield says, lies in the fact that the investment market encompasses stabilized properties, as well as facilities that are newly built and in lease-up mode. While lenders are exercising more caution on financing acquisitions of newer product, capital remains readily available for facilities with stable occupancies and cash flows.
“If you have a stabilized property that’s cash flowing, you will field demand from all types of institutional capital, including REITs,” says Mellon of JLL. “REITs haven’t disappeared from Texas, but they’re more focused on targeting cash-flowing properties.”
Both Mellon and Johnson of Bellomy believe that in general, investors targeting self-storage deals in Texas are demonstrating a more sophisticated understanding of the space. This savvier approach to investment incorporates more analytics, which translates to investors being better equipped to evaluate the supply-demand balance when deciding whether to buy, sell or hold.
In addition, the growth of the industry has enabled lenders and investors to better grasp its nuances, which has in turn opened the doors for different types of buyers to enter and expand in the market.
“The buyer pool over the last 12 to 18 months has really transitioned into new money and equity for self storage,” says Johnson. “We’re seeing non-REIT institutional money, as well as private equity firms and 1031 exchange buyers from other states continue to target Texas because they see how strong our economy is and how sound the fundamentals are.”
Johnson adds that cap rates are compressing for stabilized properties — those that have generally hit and maintained an occupancy rate of about 85 percent and which have offered minimal rent discounts and concessions.
Many investors are partnering with national and regional owner-operators and being more selective about their purchases, sources concur. In addition, most self storage REITs are exercising cautious aggression and placing a premium on ensuring they don’t overpay for assets that are engaged in wars for occupancy and revenue. REITs typically have the most bandwidth for marketing, another critical concern in a saturated market.
In many ways, the Texas self storage market has followed a common cyclical trajectory over the past five to 10 years. But developers, investors and brokers within the space all appear to be keenly aware that the cycle is on its last leg.
The runway for new development is longer in secondary and tertiary markets. On the flip side, these cities may lack the job and population growth to justify new projects.
Property taxes on self storage assets are generally rising across the state. But some municipalities are growing wary of the property type as the competitive environment puts downward pressure on how much money they bring in, sources say.
The million-dollar question centers on how long it will take for the market to absorb existing supply and be able to bear positive rent growth once again. The answer to this question will vary from submarket to submarket, but in the meantime, the focus in the Lone Star State is on maximizing income streams at existing facilities rather than expanding footprints.
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