Mar 8, 2022
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 min read

Underwriting My First Storage Deal

Being an entrepreneur is risky. I left my stable career in finance 17 months ago, and since then, I have been working to build businesses that bring not only more value into the world but also more flexibility, happiness, and independence to my family. During this journey, I’ve realized the importance of diversification. Apart from keeping a high cash balance, the best thing I can do for my financial situation is to continue to diversify my “portfolio” across asset classes, businesses, and other investments.

While I have almost no experience in real estate, I’m realizing the importance of having exposure to it either through investments with managers or through direct investments. Having been a tenant myself, I don’t have any interest in buying and managing small multi-family properties. The thought of purchasing a duplex and renting out one of the units isn’t that attractive either as my wife and I are considering eventually leaving the Bay Area. In addition, I’m a complete failure when it comes to construction and handyman work. What I am good at is utilizing technology and systems to increase the revenue and profitability of antiquated businesses. For this reason (and several other reasons which you can find on Twitter), I decided to explore self-storage.

As I think about this investment, I by no means need to buy a storage facility, so I can be selective with my potential investments. I consider this to be a huge advantage for two main reasons:

  1. I’m new to this asset class and need wiggle room as I learn the business and manage operations.
  2. The market for assets like this “may” be elevated right now. I don’t want to necessarily buy at the peak since I’m not an experienced operator.  

To ensure that I was being thoughtful about my investments, I took a direct sourcing route. You can read more about my approach to finding and contacting opportunities here. I’m slowly going after four markets that interest me:

  1. Bend, OR (where my business is located)
  2. Northern Michigan (where both my family and my wife’s family is located -we’ll spend 2-3 months a year here for the rest of our life)
  3. Milwaukee (where I grew up and have lots of connections)
  4. Savannah (cool area I wouldn’t hate to move to )
Background on the Transaction:

During my outreach process, I was lucky enough to get a response from an individual who mentioned he was contemplating selling one of his facilities. I gave him a call the next day to learn a bit more, and we spent nearly an hour on the phone. Having had many calls with sellers before, I always find the first call to be a good indication of how the process may go.

The seller ran a service business for 20+ years, and he and his partner invested their profits in real estate across the state. They started in multi-family but quickly migrated to self-storage. His partner is interested in liquidating the portfolio over the next handful of years, and they’ve decided to sell 1-2 locations a year starting with the locations that are furthest away from where they live. Their kids aren’t interested, so they’re looking for new buyers. They sold the first facility in 2021 and are slowly moving forward with their plan. While they eventually need to sell, he made it clear to me that he wasn’t a forced seller and was willing to be patient.

As I learned more about their portfolio, I was remarkably impressed. They own all the facilities 100% outright and have absolutely ZERO debt on any of the properties. He answers 100% of the phone calls and manages everything himself. He has individuals who help at each location when a unit needs to be opened in exchange for a free unit. Across his facilities, he gets anywhere from 100-500 calls per month. Having had several calls with him, I have seen that he always picks up before the 3rd ring, and he credits the success of his facilities to just always picking up the phone.

Importantly, he has no set prices and uses a range of prices that he provides tenants with whenever they call. He believes this method has been critical to his success in keeping all his units nearly fully occupied for his entire time as the operator.

While I was impressed with all of this, in the back of my head, I was curious about the potential for improved pricing rules and the potential to automate with technology and a team of assistants like I use at my other businesses.

Initial Underwriting:

After getting some high-level information from the seller, I started the fun part of the process. As a business nerd and former financial professional, I’m lucky to have the necessary financial modeling skills to underwrite the business. However, I’m a self-storage noob, so I was excited to jump into the analysis here and learn something new. I want to thank Jeffrey Rasco for spending an hour with me on the phone to answer my dumb industry-specific questions. Twitter is an amazing tool, and you meet the best of the world on here. Thanks again, Jeffrey. Before I jump into the actual financial model, I wanted to share some of the “softer” analysis work that I did. To be clear, this softer work is far more important than any financial modeling work. When garbage goes into the model, garbage comes out.  As many of you know, I’m a huge fan of scorecards and creating a process for my diligence, so I of course made one for storage facilities. Here’s my first high-level scorecard:

  • Importantly for this transaction, the seller is selling two facilities that are within 8 miles of each other as a bundle. One has 20 units, and the other has 60 units.
  • These facilities are in 3rd or 4th tier locations. Rural townships of 10-15k people within 30-45 minutes of a 100k person county that is growing at 5% a year. Importantly, I’m very familiar with these locations as they’re directly between both my wife’s and my family’s homes. This area is a summer hotbed with the population doubling in the summer due to residents flooding in from other parts of the state and country. The location has been featured in WSJ, NYT, and other big travel magazines. While the seasonal, resort nature of this area is cyclical, most of the visitors own second homes here, and there are relatively few hotels and resorts. According to the seller, the tenants represent a mixture of full-time residents and seasonal residents who need to store extra things.
  • With the nature of this market, I’ll want to be conscious of capacity and ensure there are not a lot of new entrants in the market. Interestingly, as I did more research, I learned that someone built a new storage facility directly next to the facility I was looking at over the last four years. According to the seller, he hasn’t seen any change in demand. The other facility is charging 30% higher prices, and is 100% occupied so I imagine it may be creating more demand for the facility. My fear is that other new facilities are going to be built creating excess capacity which would greatly harm my investment.
  • While the nature of 3rd or 4th tier locations adds risk to any transaction, this area is growing, and more wealthy individuals continue to move here every year. Importantly, the biggest risk in this location is the potential liquidity risk. There are likely few buyers that want to purchase in this area as most institutional buyers won’t drop to this level. I may struggle to sell this property if I need to. I’ll want to increase my equity commitment on the deal to reduce the risk that I’ll be a forced seller without a large list of buyers. On the other hand, this may work in my favor during the negotiations as the seller probably can’t create a competitive process.
Revenue Quality:
  • In the initial diligence, I can’t dive into the quality of the revenue in as much detail as I’d like. As I get more information, I’ll be sure to touch on this more. What I do know is that both facilities are running at 95%+ occupancy and have an average occupancy duration of ~5 years. In my opinion, that’s a positive sign as I think about the sustainability of revenue. I’ll want to dive into the skew of these durations, but it makes me even more confident that there are tenants paying well below market who are unlikely to leave if I raise prices. The seller said he occasionally raises prices, but he is not systematic about it and just prefers the cash flow coming in.
  • To better understand the competitors in the same market, I needed to do some competitive analysis to better understand three things: Pricing, Occupancy, & Quality.
  • To start this process, I leveraged Google maps to make a list of all the facilities within 20 miles of these two properties. I compiled general information using their websites, images, and satellite views I could see online. There were about 15 smaller facilities within this distance and only 4 had prices online for me to view. These were the only facilities that were using “modern” websites and only one allowed a customer to reserve a unit online. This was a positive in my mind as I think it would be possible to differentiate against most competitors in this area.
  • Importantly, I need to figure out how pricing compared at all these units. To do this effectively, I called all the facilities on the list to get updated pricing and to see if they had space. The results were shocking. 11 of the 15 facilities were completely full, and they weren’t even taking a waiting list. In terms of pricing, the facilities I’m looking at are in the lower range and the ones with modernized websites were charging 25-40% more for the same size units. All positive signs.
Facility Quality:
  • In initial diligence, it’s tough to judge the facility quality when I’m nearly 3,000 miles away. The owner let me know that he replaced all of the roofs on the buildings over the last two years, but I can’t tell the quality of the doors and the rest of the structures. If I’m able to get the deal under contract, this is where I’ll want to spend a lot of my time and diligence resources to ensure I’m not buying anything that will need major capital repairs over the next 5-10 years.
  • I did spend a lot of time on Google maps judging the pictures and satellite images. It’s clear these are rural facilities with no fences and dirt roads. All downsides, but they match the area well and should be relatively more safe than a facility in a more urban area. Only one has electricity, so I’ll want to consider how important or necessary that is. If I were able to purchase the facility, I’ll want to add cameras, so I need to better understand if that’s feasible with the current electrical wiring.
Operating Costs
  • Apart from revenue growth assumptions, this area is where I’m making the biggest assumptions. I’ve never operated a facility so all of my go-forward assumptions are based on online research and speaking to people smarter than me.
  • As I mentioned above, the seller operates these facilities with almost ZERO overhead and takes every call himself. His only line items for operating costs are property tax, plowing, insurance, electric, and software. In total, he’s running the facility at less than $1 per square foot which is quite impressive for a facility as small as this one. Unfortunately, I won’t be able to run the facility nearly as efficiently as he does, and frankly, I don’t think I want to. As I predicted my operating costs, I made a few assumptions and added some new categories:

Property Tax: This was where I thought I’d see the biggest change since the seller has owned this property for a long time. I dove into millage rates and got very confused until I called the assessor in each town, and they were able to outline almost exactly what my new property taxes would be for each of these properties. Post-transaction, property tax expense would increase 100%. I actually thought it would be worse, so I was happy.

Plowing: I didn’t spend a ton of time estimating new costs and just increased the cost by 25% for a new contract with the cost increasing 5% per year.

Insurance: I haven’t gone out and got an adjusted quote yet. I just assumed a 50% increase in the initial cost with a 5% increase per year. Thankfully, this facility isn’t in an area with natural disasters or flooding.

Electric: I didn’t spend a lot of time on this but just assumed a 5% increase per year.

Software & Website: Since the seller is only using basic software across all of his units the actual software cost for each location is almost nothing. While I held back my jealousy for his economies of scale, I researched and adjusted the software costs to the actual price of the best software in the industry. In addition, I added a small fee for building and hosting an up to date website.

Legal & Accounting: Relatively standard, but I added the cost for managing the LLC and filing taxes for the year. I can probably handle this with my current accountant under our agreement, but I wanted to be as conservative as possible.

Assistant: I use virtual assistants for my other businesses and manage an online phone system where they answer and route calls. My process would be the same for this business, but I’m guessing I would have to increase pay or hire an additional person to manage this business. I wanted to be sure to factor in this cost.

Reserve: Repair and maintenance costs come up with physical assets, so I wanted to factor in an annual repair and reserve budget. To do this, I researched average reserve ratios for self-storage facilities and chose the highest rate I could find. I’m hoping I don’t spend this amount each year, but I imagine over the long-term, this will be the average.

Financing & Legal:
  • An important part of my financial modeling was understanding the cost of debt and typical terms for a facility like this. I was able to get high-level rates and terms online, but this is a small facility, so most larger lenders won’t waste their time on a loan this small. I reached out to five smaller local regional banks with assets ranging from $100m to $1b. All five were interested in lending against self-storage in the region. They typically lend for prime plus 100 basis points which comes out to anywhere from 4.25% - 5.00% interest with a 15-20 year amortization period. Most were willing to fix it for 5 years with an option to extend to 10 years at new rates. This seems like it could be an asset to prevent me from stressing about refinancing the facility in 5 years when the term comes up. I stupidly forgot to ask about prepayment penalties, but when I go out for official bids from the lenders, it’s one of the things that I’ll be considering. I’d love to have the option to pay off the facility.  
  • For a variety of reasons, I’m likely putting down 35% of this transaction in equity, so most lenders mentioned that the underwriting process would be quite easy and that they’d love to lend to me. With this large equity investment in the deal, I’m not maximizing returns, but I’m maximizing my return based on the risk I’m comfortable with.
  • I was lucky enough to get a recommendation for a lawyer in the area that has helped a close contact of mine with a lot of real estate deals. I spoke to him, and he is ready to go as soon as we get the verbal go-ahead from the seller.
Negotiations & Next Steps:
  • I submitted a verbal offer to the owner and am waiting to hear back. If they want to move forward, I’m ready to move forward with a 60-day close. As the transaction moves forward, I’ll share more about my modeling and how I decided what the asset was worth to me. Stay tuned.

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