Due Diligence Part 3 - Non-Storage Leases

In the world of self-storage acquisitions, due diligence extends far beyond examining the physical property and standard storage leases. Non-storage leases, including those for commercial spaces, retail units, cell towers, billboards, and residential units, play a critical role in determining the overall value and potential of a facility. Each type of lease presents unique challenges and opportunities, with varying terms, escalators, and legal considerations that require a thorough understanding to maximize value. This critical review aims to outline the key elements of non-storage leases and why addressing them early is essential for a smooth and profitable transaction.

Critical Review of Non-Storage Leases

When acquiring a self-storage facility, it’s vital to identify and assess all non-storage leases early in the due diligence process. Each type of lease presents unique considerations that can influence both the immediate and long-term financial performance of the property:

Commercial and Retail Leases: These leases, often tied to businesses operating on-site, require careful evaluation of terms such as lease duration, renewal options, and rent escalators. Understanding the timing and scale of future rent increases is essential for accurate financial forecasting and aligning these leases with your overall investment strategy.

Understanding the details of a commercial lease is essential to managing costs and avoiding surprises. One important distinction is between Triple Net (NNN) leases, Full-Service Gross leases, and Percentage leases. In an NNN lease, the tenant pays for base rent plus property expenses like taxes, insurance, and Common Area Maintenance (CAM) fees, which can fluctuate based on property needs. A Full-Service Gross lease, on the other hand, bundles all operating expenses into the rent, offering tenants more predictable costs since the landlord covers expenses like utilities, taxes, and maintenance. Percentage leases are typically used in retail spaces, where tenants pay a base rent plus a percentage of their gross sales. Each lease structure has different implications for both landlords and tenants, making it crucial to review terms carefully and understand how each type affects the overall financial responsibilities.

Cell Tower Leases: Cell tower leases are agreements between property owners and telecommunications companies that allow the telecom company to install and operate a cell tower on the property. These leases typically involve long-term agreements, often spanning 20 to 30 years, with multiple renewal options. In exchange for providing space, the property owner receives rental income, which can be structured as a fixed monthly or annual payment. Additionally, some leases include rent escalations, where payments increase at set intervals. Cell tower leases can be highly valuable as they often require little maintenance or involvement from the property owner. However, negotiating the lease terms carefully is crucial, as these leases can significantly impact future property development or sale due to restrictions or easements related to the tower.

While cell tower leases can provide a substantial revenue stream, they often come with specific clauses like rights of first offer (ROFO) or rights of first refusal (ROFR). These clauses give the tenant priority in purchasing the lease or property, which can complicate your transaction timeline if not addressed early. It’s important to identify these clauses early on, as they often require a 30-day notice that could otherwise delay your closing process.

Billboard Leases: Billboard leases are agreements between property owners and advertising companies that allow the placement of billboards on the owner's land in exchange for rental income. These leases can range from short-term to long-term contracts, often lasting several years, with options for renewal. The rental payments are typically structured as a fixed monthly or annual rate, but some agreements may include revenue-sharing provisions where the property owner receives a percentage of the advertising revenue generated by the billboard. Rent escalations, where the lease payments increase over time, are also common. Billboard leases usually require minimal involvement from the property owner, making them a passive income source. However, it's important to carefully review terms regarding property access, maintenance, and potential restrictions on future property use, as billboard placements can limit development options or create visibility concerns for other tenants or structures. Restrictions and/or easements can also affect future property development or sale like cell tower leases.

Like cell tower leases, billboard agreements can generate additional income but may include ROFO or ROFR clauses. Early identification and understanding of these clauses are crucial to avoid potential roadblocks in your acquisition process. Additionally, consider the strategic value of the billboard location and its alignment with your property’s long-term goals.

Residential Leases: Leasing apartments at self-storage facilities to parties not affiliated with the storage operations can provide additional income for the property but requires careful management. These residential leases are separate from the core business and must comply with local housing regulations, unlike on-site manager apartments tied to employment. While leasing to third parties can boost revenue, it's important to consider potential challenges, such as increased property management responsibilities and possible conflicts with storage operations. Properly structuring and monitoring these leases ensures they align with the overall objectives of the facility while maintaining operational efficiency.

On-site storage managers often occupy an apartment at a storage facility as part of their employment, providing them with convenient access to the property for daily management and customer service. This arrangement differs from a traditional residential lease in several ways. Unlike a standard lease where tenants pay rent and have full autonomy over their living space, the apartment in this case is usually tied directly to the manager’s employment. The housing is provided as a benefit or requirement of the job, and in many cases, no rent is charged or it may be heavily discounted. Additionally, the use of the apartment is contingent on the manager's continued employment, meaning they may be required to vacate the unit if they leave or are terminated from the job. The terms governing this type of arrangement are typically outlined in an employment agreement rather than a standard residential lease, emphasizing the functional role of the apartment in their work rather than its use as a personal residence. Pay particular attention to lease terms, employment contracts, renewal clauses, and rent escalations.

Evaluating Non-Storage Income on a P&L: Impact on Valuation and Cap Rates

Non-storage income is typically booked under a separate line item on the profit and loss (P&L) statement, distinct from the traditional storage rental income. This separation is important because non-storage income can have different financial dynamics, often with lower operating expenses or different contractual terms, which directly impact profitability. In evaluating the facility’s overall value, non-storage income may be assessed using a different capitalization (cap) rate than the primary self-storage income, as it may be seen as less stable or long-term, depending on the nature of the revenue source. For instance, while storage rental income might be evaluated at a lower cap rate due to its recurring and predictable nature, non-storage income may be assigned a higher cap rate, reflecting perceived risks or market variability. Differentiating these income streams provides a clearer financial picture and can impact how the facility is valued by potential investors or lenders.

Maximizing Income Through Expert Negotiation

For cell tower and billboard leases, it can be beneficial to engage a third-party expert who specializes in negotiating these types of leases. These professionals have in-depth knowledge of market demand and can often secure better terms, resulting in increased revenue. The additional income generated by renegotiating these leases typically outweighs the cost of hiring a third party, making it a worthwhile investment for maximizing the value of these agreements.

The Importance of Estoppels

An estoppel is a legal document used in real estate transactions to confirm the current status of lease agreements, and it is particularly important for non-storage leases in self-storage transactions. Estoppels verify essential details such as lease terms, rent amounts, expiration dates, and any outstanding issues between the landlord and tenant. Estoppels are critical because they protect both buyers and sellers by preventing future disputes over lease terms and tenant obligations. In self-storage deals, where properties may include non-storage leases for things like retail space, cell towers, or billboards, obtaining estoppels is essential for accurately assessing the value and risk associated with those leases. The timing of obtaining estoppels is crucial to the due diligence process, as delays in securing them can cause significant holdups in verifying lease conditions, potentially delaying or derailing the transaction. Estoppels must be collected early in the due diligence period to ensure all lease terms are clear and undisputed before the deal moves forward.

Conclusion: A Proactive Approach to Non-Storage Leases

Successfully managing non-storage leases requires a proactive approach, both during the due diligence phase and post-acquisition. Thorough due diligence, including the timely obtaining estoppels and expert negotiation of non-storage lease terms, is critical to ensuring that these income streams align with the overall investment strategy. By understanding the nuances of non-storage income and its impact on the P&L, investors can make informed decisions that lead to enhanced profitability and long-term success. Remember, the time and effort invested in this process are crucial to mitigating risks.

Stay tuned for the next installment in our series, where we’ll continue to explore key aspects of post-closing due diligence file organization in self-storage acquisitions.