If you’re in the self-storage industry, it’s likely that you’re familiar with AJ Osborne. With 20-years experience in the field, Osborne has been instrumental in educating investors and enhancing business efficiency for others in this sector. He owns, operates, and has developed over 3M sq ft across 30+ self-storage facilities and is the CEO of Cedar Creek Capital, a self-storage private equity investment firm. Additionally, he is a founding member and current board member of Storelocal, the largest self-storage co-op, as well as Tenant Inc., a SaaS (Software-as-a-Service) company that supports the management of self-storage facilities.
Suffice it to say that Osborne knows the industry better than most, and if you didn’t believe that statement before, you are certainly about to. Back in May of 2022, Osborne warned everyone that the self-storage bubble was starting to burst. Barely over a year later, and it officially has. So what does this mean? And, more importantly, what does this mean for the industry? Here, Osborne explains.
The Risk to the Industry
Osborne saw something going on and decided to discuss it in length. He felt that nobody was addressing the huge risk in the self-storage industry back in 2022, which was the changing landscape of the economy, how it was impacting the self-storage industry as whole, and the lack of overall knowledge.
“I thought it was due to self-interest (aka investors wanting the industry to keep booming) but I realized it’s something different,” Osborne said. “The biggest exaggeration I saw in the industry was this— ‘Self-storage is recession-proof.’ Most could not see or imagine self-storage declining.”
While the numbers were true, they leave out the fact that self-storage also had the lowest debt to income and equity in 2008. Why? Osborne explained this is because banks didn’t like to lend to self-storage, leaving most assets with no debt or under 50% debt to equity. Many had high occupancies but lost 50% of their revenue. They were giving units out for free, or people just stopped paying. But they survived and did well compared to other assets.
Self-storage did not have any major institutional third-party management companies and had never been through a credit crisis so institutional investors did not play in the space. This created a massively underserved industry filled with mom and pops. Many were simply land holds, and the investors didn’t care about operations or maximizing revenue. It had not been through a major expansion like all other assets in the 90s and early 2000s. But after 2008, this all changed.
Osborne went on, “Big third-party management companies, like ExtraSpace, came out and you could model their self-storage performance, and institutional capital could come in and take over.”
The CEO of Public Storage said “third party management is the worst thing in the industry and will be its downfall.”
Due to a lack of development prior to 2008 and through the recession (combined with low-interest rates and people moving), the demand for self-storage grew. Revenue and occupancy rose and cash flow exploded (due to the low cost & low debt margins). Returns outpaced every other commercial real estate asset. Osborne said it was then that investors took notice and demand grew rapidly driving costs and dropping cap rates.
Institutional investors meant higher sales prices and market consolidation. Over the next 10 years, cap rates would go down to never seen levels and price per square foot would skyrocket. Big money plus low cap rates led to a development boom, unlike anything in self-storage history.
“Self-storage was now in a development cycle that other industries had gone through prior to 2008. Debt chased the assets now viewed as extremely safe and everyone took a lot,” said Osborne. “Facilities became high-end, out of the industrial park and into nice neighborhoods with expensive add-on services. Operators became much more sophisticated, looking more like hotel companies and leaning on new technology to maximize their competitive advantage. This is when the players changed. As returns outperformed other asset classes, the real estate community took notice.”
Leading Up to a Shift in the Industry
In 2016 there was a big change in the industry. As Osborne explains, private equity, new investors, everyone all wanted a piece of the self-storage pie.
Inexperienced Fund Managers dominated acquisitions, paying premium prices that pushed both REITs and experienced long-term companies out. These were investors that had never operated a self-storage facility, let alone experienced a period in which occupancy declined and cap rates increased. This was evident in their acquisitions, deal structures, and underwriting, which he says is a key element to recognize.
The industry shift in 2016 accelerated in 2018 and we started to see occupancy drop along with revenue. Then a catalyst entered, Covid, saving many self-storage developers struggling to increase occupancy at rental rates that were lower than planned and underwritten.
“Covid hit right at the end of this massive development cycle. No one would have expected it, but this was a huge boom for self-storage,” Osborne said. “Low-interest rates plus people not going to work, combined with secured incomes fortified by checks from the government? People went out and bought homes, RVs and toys.”
Occupancy rates shot up to levels never seen, and rates soon followed. Massive rate increases paired with low inventory will always make good numbers look even better, especially in the short term, Osborne points out. During this period, other assets suffered, inflation entered and even more investors sought refuge in self-storage. Some only having been in the game for four years, were raising hundreds of millions of dollars and buying everything they could.
“Something important to note is that self-storage is directly correlated to the housing market. People moving is good for business. As interest rates rise and the number of houses sold drops, so will self-storage occupancy and revenue,” he adds. Housing market stagnation has a huge negative effect on self-storage occupancy.
Osborne explains, “Investors buying assets at these record high prices are expecting their profit/returns to come from a sale and exit. This strategy requires a future equity conversion event to produce profit and underwritten in a way that those returns from exiting are distributed across the years the asset is held. Returns are projected and predicated on the event I like to call “event-driven investing or gambling.” This strategy is dependent on maintaining high occupancy, producing an even higher revenue, and an economy sustaining and supporting historically low cap rates.
It can be highly lucrative and this fact alone becomes their justification to pay such high prices. However, every investor must know where they are at on the risk to reward spectrum. Holding true to gambling- this strategy is equally as high in risk.
To mitigate risk, be aware of the economy and various market conditions. If operating in an over-built market while interest rates rise and housing slows, your occupancy will drop and cap rates will rise. What that means is the equity event that you were dependent on and thought was the pot of gold at the end of the rainbow, has now become a bomb waiting to explode.
Osborne explained it this way to reiterate his point:
|At Purchase||After Purchase [10% Drop in Occupancy]|
“That’s a $700K loss even if the facility cash flows. Refinancing or exiting is no longer an option because you have lost all equity and are now underwater. In the end, I believe that the long-term value proposition of storage is great, but many will struggle through this change as performance returns to normal mature asset.” he said.
The Bubble has Officially Popped – Now What?
As anticipated by AJ over a year ago, Osborne has made it clear that the bubble has officially popped.
“The rental rates we can charge are dropping, along with new customer acquisitions and overall income.”
In fact, Wall Street Journal has confirmed this with a recently published article reporting the largest rate drop in self-storage history.
So now what? What happens to all the facilities out there that were bought during the previous bull market?,” he asks. “If you were conservative in your underwriting, purchased in a great market, planned on a long-term hold and did not structure your investment dependent on an equity event to profit, you should be fine. If not, I’m here to tell you that it’s time to be smarter with your strategy. I’m not trying to scare you, but understand that self-storage is self-correcting and you have to pay attention to what is happening in the industry right now. As the industry matures, it will create a vast amount of wealth but require more work than the last 10 years. Which is not a bad thing.”
About AJ Osborne
AJ Osborne is the CEO of Cedar Creek Capital and has an impressive 20 years of experience as a self-storage owner, operator, and developer. He is a founder and board member of the largest self-storage co-op, Storelocal, as well as Tenant Inc – a SaaS company supporting self-storage facility management. AJ has also written the No. 1 bestselling book on self-storage investing and hosts the top rated and listened to self-storage podcast, Self Storage Income. Accredited investors can find more information here: https://www.cedar.cc