I want to follow up my last post where I discussed my predictions of an occupancy decline and where I think we’ll see distress with a big update based on a deal I analyzed this week.
A Deal This Week Changed My Mind About Distress
In my last edition, I stated that I believed large Private Equity funds would face the most distress because they bought in at outrageously high valuations relying on quite aggressive assumptions with floating rate debt. And while I still believe this to mostly be true, I think we’re really going to start seeing distress with developers in self-storage.
The deal that really got me thinking was a brand new multi-story climate controlled facility in a tertiary market in lease-up listed for sale at replacement cost, something I simply have not seen in the last 2 years. Plugging in the numbers, my offer arrived 50% below list price.
Why? To achieve an acceptable risk-adjusted return with today’s construction costs and interest rates, you must be able to rent units at ~$1.60/sqft/mo for single-story climate controlled product and $1.80/sqft/mo for multi-story. This owner is targeting only $1.19/mo, which is top of market, and even then he’s giving a 50% off discount for 3 months.
Even if this owner leases his facility up to 85% occupancy at these $1.19/mo rents – he’s still going to be losing money every day, there’s no way to shake that reality. As a buyer, you realistically need to be coming in at around an 18% discount just to break even on debt once you are stabilized – let alone actually make money.
The Distress
I’m guessing what happened to this developer is that he modeled a modest return in 2020, spent a year and hundreds of thousands on predevelopment costs and planning, only to be retraded by his builders at 2x cost. Due to the boom in construction costs, 2021 and 2022 developments HAD to target aggressively high rental rates that, in many markets, are simply not achievable anymore.
Combine that with a doubling of interest rates, there will be developers in distress.
The Play
In 2021, this deal trades above ask. Today it will be purchased for 15-25% below list and the developer and his investors will probably lose a lot of equity. A 15-25% drop in aggressiveness is a huge change in a reasonable direction for class A product in lease up, but it’s still not enough.
The opportunity I am seeing is that class B product in lease up does seem to be approaching reasonable price territory. These listings are getting far fewer bids as folks flock to attractive lower risk in-place yields and the actual bids that are coming in seem to be far below last year's by 25-35%. That means if last year a buyer would accept a stabilized 7% yield, this year they're targeting a stabilized 8-8.5% yield. At the 8.5% and up mark, my ears perk up!
Leasing speed across the country is slowing due to the housing market slowdown, but real estate is hyper-local, not every market is slow, and not every market that is slow today will be slow forever. I believe that we will find a few deals this year underpriced due to excess-fear related to lease up risk, in markets in which supply/demand imbalances indicate that a lease up could be quick, at purchase prices that are both supported by market rents and below replacement cost. This is where I’m starting to see opportunity, and we’ll be paying a lot of attention to these types of deals this year.
Thank you all for reading! As always, please let me know what you liked/disliked about this article and what you would change. If you're not on our deal list and would like to learn more, find a time here: https://calendly.com/ryan-rwoodstorage/30min where we can meet!
Thanks!
Ryan
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