The Self Storage Development Cycle and Exit Strategies

There are a few things I wish I had learned vicariously, like smelling the tuna in the refrigerator before eating it and not doing yoga in the shower. Lessons in life are hard but incredibly valuable for living our best lives. Lessons in business, however, are not always as forgiving as eating a bad tuna fish sandwich. Sometimes, they can be downright financially ruinous. I have been fortunate to be part of the self-storage development industry for more than a few business cycles. During this time, I have had amazing mentors to learn from, witnessed the mistakes and successes of others, and experienced my own hard lessons.

Through it all, the self-storage industry continues to grow. One lesson I see repeated is that winning and losing often depends on understanding the self-storage development cycle and the available exit strategies. This is crucial for optimizing return goals and minimizing unexpected risks.

The development cycle has several phases. It begins with site selection and proceeds to contract negotiation and execution. Once a target is under contract, due diligence begins, and simultaneously, the zoning, use, and site plan approval process can commence. Ideally, upon full site plan approval, the contract is closed, and the purchase and sale of the land are consummated. During the final stages of site plan approval, the architectural plans are developed and put out to bid with qualified general contractors. A construction contract is signed, and construction begins. Upon construction completion, a certificate of occupancy is issued, and leasing begins. The property then enters the “lease-up” stage and eventually stabilizes.

Depending on several factors such as the market, the land use attorney, the civil engineer and architect (design team), the seller’s focus, and capital availability, this development cycle can take 24 to 48 months or even longer.

The first consideration before beginning the development cycle is to know your critical path from beginning to end. There are four main points within the development cycle that I focus on: What are the contractual timelines? What municipal approvals are required? What is the construction timeline? And what is a reasonable lease-up schedule?

The next question to ask is: What are the capital requirements? Each stage has its own costs and expenses, and the deeper into the cycle you take the project, the more capital is required. The flip side of this coin is that the further along in the cycle the project is held, the greater the value created. This begs the next question: What is the value of the project at each stage of the development cycle? These two questions will help develop an optimal exit strategy.

As nothing lasts forever, an exit strategy should always be in mind. The self-storage development cycle itself offers five primary deal exit points: Site Selection, Land and Plans, Certificate of Occupancy, Lease-Up, and Stabilization. Each of these five points has its place, accommodating differing capital requirements, investment time horizons, and return expectations.

The guiding principle in this calculation is that over time, the capital investment grows steadily, while ROI should increase at a steeper rate, indicating higher profitability the longer the hold time is in the investment.

Cycle Phases and Corresponding Exit Strategies

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Site Selection

The first and perhaps most important task is identifying a good site for a self-storage development. One of the biggest mistakes I see is a poor site being developed for storage. The result will be reflected in a slow lease-up rate and poor rental rates against the market. Additionally, the second-order effect of bad site selection will be suppressed rental rates in the overall market as the additional supply places downward pressure on competitor rates.

Site selection comes down to market, location, zoning, and, of course, price.

Before anything, know the market. What is the population density? What is the supply? How much supply is new and still in lease-up? How much new supply is planned? What are market rents? It is very difficult, and at a point, impossible to pay for the construction of a Class A facility in a low rental rate market and still achieve a good return.

Next, as the old adage quips, “location, location, location.” Never forget that self-storage is a real estate play and fundamentals matter. Early in my career, a mentor once told me that a good storage site is one that Mom and Dad drive by every day to buy their milk and bread and drop their kids off at school. A good facility will market itself with its presence. On the other hand, a location out of sight will be out of mind when it comes time for Mom and Dad to rent. Visibility is important. Just as important is access. All too often, I see sites that are visible from the highway, but very difficult, circuitous access.? I call these facilities “Statue of Liberty” sites. They are visible from everywhere but impossible to get to.

The next consideration is zoning. An as-of-right zoned property will shave months off the next phase, Site Plan Approval. It will be a large savings in time and money. There are a few things to consider when it comes to zoning. First is use. In most municipalities, a use variance is a non-starter and is rarely granted. Some municipalities will allow a zoning change, which is possible but can be costly in legal fees and time. Another zoning issue is the allowable buildable envelope. This is usually defined in the zoning text in one of two ways: as a prescribed floor area ratio (FAR) or by coverage allowance, setback requirements, and height restrictions.? The question must be asked and answered, how big a facility can be built on this site.? One question I am asked often is as a developer how big a piece of land do I need.? This is the wrong question.? The question is how big a building do I need to build and then how much land is required to build that facility?

Even at this early stage, good money can be made with an early exit. Historically, this has been the role of brokers who have been making money from it from time immemorial. Typically, brokerage commissions will range from 2-6% of the land price and will be paid at closing.

The value of the land to a buyer developer changes according to the business cycle but will always offer the best return over the long term for them. ?Personally, the best deals I have done have begun at this stage.? In today’s market, the buying developer is looking to earn a return on investment, cash on cash, of +/- 8%. The amount the buying developer can pay for the land can be calculated by backing into the 8% ROC. This calculation runs as follows: (Total Hard Cost + Soft Costs + Land Cost) / Stabilized NOI.

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Site Plan Approval ("Land and Plans")

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The role of packaging and selling a fully approved site has historically been a very profitable business model. Entire companies have sprung up wholly focused on packaging and selling the single product of a fully approved self-storage site.

Investing in site plan approval involves several critical financial commitments. These include costs associated with land purchase. (Alternatively, many merchant developers will tie up a parcel of land with an assignable purchase and sale agreement and then assign the contract to a buying developer at closing.) Additional costs include legal fees, due diligence investigations, architectural site plans, and civil engineering plans.

The buying developer’s financial objective varies depending on the business cycle but is always correlated to the return expectations of the site selection expected returns. As a rule of thumb, a 50 to 100 basis point premium will be paid by the buying developer to the merchant developer for a land and plans deal. That 50 to 100 basis point premium on the entire final project cost is the merchant developer’s revenue to cover all costs and profit.

When the economy is strong, when equity and debt are both available and affordable, there is a large buyer pool of developers waiting in line for these deals.? I have used such strategic partnerships to build out entire markets, and for good reason. One of the first maxims I learned in development is that all real estate is local. National developers just don’t possess such local knowledge. ?The advantages of utilizing a merchant developer network for buying developers are many. The merchant developer can take advantage of their local knowledge of the real estate market. They can also often better navigate the local municipal approval structure and politics along the critical path of site plan approval. Then there is the speed-to-market aspect. The shovel readiness of the project could shave 8 to 24 months off the development cycle for the buying developer. Time, in this instance, truly is money.

Warning: as I mentioned above, the viability of this model is very much influenced by the business cycle. Using myself as an example, as I already mentioned, over the last several years, I have purchased many such projects. In each of these instances, the merchant developer was well rewarded for their effort because the ratios between the cost of land, hard and soft costs, operating expenses, and market rental rates were such that there was plenty of meat left on the bone for everyone to profit.

Over the past twenty-four months however, the margins on these shovel-ready land and plan deals have evaporated, making them all but impossible to work. Of course, there are always exceptions to every rule, but for the most part, market conditions in 2024 have put the kibosh on this exit strategy plan. Buying sellers just can’t pay or are unwilling to pay the premium they once did to make it worth the time and costs for merchant developers.

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Certificate of Occupancy (C/O) Sale

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Next to buying a property at the beginning of the development cycle, Certificate of Occupancy deals are my personal favorite. Within the last twelve months, I was fortunate enough to be involved with two C/O deals. Both are in high rent, densely populated New York markets.

There are many advantages for self-storage owner/operators to purchase C/O deals, and many profit points for merchant developers as well. For the owner/operator, there is again the speed-to-market aspect in play. An operator can open for business on the day of closing, shaving eighteen to thirty-six months off the development cycle. The operator can also avoid all the risk associated with the approval and construction phases of the project, which can be substantial. Finally, an operator can enter a desirable market without having to build yet another competing facility, mitigating the risk of oversupplying that market.

The merchant developer’s investment required for a C/O sale encompasses the total project costs, interest payments, plus construction management fees, which typically account for about 4% of the construction cost. The sale of the property plus the construction management fee becomes the merchant developer’s revenue.

The expected return on investment at this C/O stage is also correlated to the baseline of the full development cycle from site selection. As a guideline, a buying operator will pay a 150 to 200 basis point premium on the cap rate. When a market bears a cap rate of 8% for a full development cycle deal, the merchant developer can expect a cap rate on projected stabilized NOI (net operating income) of 6% to 6.5%.

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Sale During Lease-Up

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This phase presents significant challenges in valuing the asset due to uncertain market rental rates and lease-up times. ?With in-place rents likely below their ultimate levels and many variables still undefined, placing a value on a lease-up asset can be likened to trying to nail Jello to the wall. Consequently, unless there is a compelling reason, purchasing projects during this phase is generally avoided. For the merchant developer, selling after C/O but before stabilization is usually an indication of financial distress, and the sale of the asset is the only exit strategy to save them from a greater loss.

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Sale at Stabilization

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The investment requirements for a sale at stabilization include all previous costs plus debt service, equity carry costs, and operational shortfalls experienced during the early lease-up period. Marketing and lease-up strategies are critical at this stage. Pre-opening marketing efforts should focus on attracting tenants, while lease-up strategies may involve competitive pricing and promotional offers to fill units quickly.

Some merchant developers will manage their own property through lease up, but many will opt for a third-party manager.? The third-party management industry, which has been brought to maturity by the REITs and a handful of very competitive private operators, has allowed the merchant developers to take full advantage of sales at stabilization. Referring to the graph above, getting to this stage of the development cycle requires the most capital resources. With increased capital requirements, the risks to the merchant developer are also the greatest. Along with the greatest risk, a sale at stabilization will provide the greatest reward.

The return expectation for a sale at stabilization in this current market should be from a +/- 5.5% to 6% cap rate depending on the quality and location of the facility.

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?Conclusion

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Understanding the self-storage development cycle and strategically selecting exit strategies are essential for maximizing returns and ensuring long-term success. By carefully planning each phase of development and considering the most suitable exit point, developers and investors can achieve significant profits and stable growth in the self-storage industry.