Health Crisis Upends Commercial Real Estate' Uncertainty Will Carry Well Into 2021
Pandemic Transforms Commercial Real Estate.
COVID-19 changed the world in early 2020 as efforts to curb the spread of the pandemic had a dramatic impact. Stay-at-home orders, the need to physically distance, and having to abide by health and safety protocols had harsh effects on many real estate sectors.
Health Crisis Exacerbated Demographic Shifts.
Employers laying off workers and sending staff home to work remotely contributed to an acceleration of demographic changes that were already underway. Economic uncertainty led many households to search for lower-cost housing, while the need to work from home and attend school online generated demand for larger spaces. Commute times became less of a factor in housing decisions, pushing residential and apartment demand away from dense urban cores that are more reliant on mass transit to the benefit of suburbs as well as secondary and tertiary markets. Higher unemployment is also leading to more people spending time at home, which consequently may have boosted new business applications to the highest rate since the Great Recession.
Possibilities for Second Growth Surge or Double Dip in 2021 Hinge on Vaccine Rollout and Labor Recovery
Vaccine distribution to play a critical role in economic outlook.
The nation’s economic situation has regained much of the momentum lost last spring as it continues along an upward path in 2021. Ongoing health challenges and other potential hurdles may suspend or abate that progress, however. If the current set of COVID-19 vaccines are distributed as efficiently as predicted, then enough people may be inoculated by midyear to safely allow most businesses to fully reopen. If, however, the pace of the vaccine rollout is slowed or the nature of the virus changes, these exogenous encumbrances to the economy will remain in place longer. Employers who are challenged by physical distancing requirements and areas of the country where infection risk is higher will fall further behind other segments of the economy. This disparity, if severe enough, could lead to another quarterly economic contraction.
Labor market recovering but some sectors are falling behind.
Over half of the jobs lost in March and April last year were restored or replaced by December, but as 2021 progresses certain industries face a longer road to total recovery than others. Physical distancing requirements and travel restrictions had a disproportionate impact on the leisure and hospitality sector, which encompasses hotels, bars, restaurants and other entertainment venues. While the overall employment base remained 6.5 percent below its pre-pandemic level at the start of 2021, the leisure and hospitality sector was still down 23.2 percent. Conversely, staff working in essential services or in positions more easily shifted to a remote setting were better protected. The number of jobs in financial activities, construction and in the trade, transportation and warehousing sector were all at or within 3 percent of their February 2020 mark by the start of the new year.
Administration Weighs Policy Goals Against Stimulus Needs While the Federal Reserve Guides Inflation
Biden administration must balance policy objectives and health crisis management.
President Biden campaigned on a platform of widespread legislative reform, including taxation, healthcare and public spending on infrastructure. Achieving these goals must be managed in relation to the immediate needs of the health crisis. Making more substantial alterations to laws and regulations could create uncertainty among consumers and investors, dampening the intended effects of stimulus measures that the Biden administration is currently pursuing.
Additional federal aid likely incoming; holds significant implications on growth.
The $900 billion stimulus package passed at the end of last year is serving as a vital economic stopgap as the country deals with the difficult health challenges. Many of the legislation’s key benefits, such as renewed federal unemployment insurance, will nevertheless fade by the spring. The Biden administration is therefore pursuing a $1.9 trillion stimulus package to further buttress the economy. While the final stipulations of the bill are almost certain to change, the incoming aid will uplift the economy in the near term, but at the cost of introducing some potential longer-term risks.
The Federal Reserve continues to carefully monitor inflation.
As this year progresses, the Fed will have to walk a tightrope balancing economic growth and the potential for accelerated inflation.
Resilient Self-Storage Sector Emerges From 2020 on Upward Path, Aided by Historically Strong Fundamentals
Initial uncertainty briefly weighed on self-storage performance.
When a wave of stay-at-home orders came into effect in March 2020 in response to the health threats of COVID-19, many commercial real estate demand factors were substantially disrupted. Self-storage properties were not immune to this trend. While storage was classified as essential business and permitted to stay open during lockdown, general uncertainty about the health situation kept many renters away from their units. Although more people sequestering at home means that fewer tenants were ending existing leases, fewer new rental agreements were also being signed.
Sector recovers in the second half of 2020, achieving new vacancy low.
As spring moved into summer and the impact of the pandemic became more clear, the self-storage sector began to demonstrate its resilience. New leasing improved as stay-at-home orders were relaxed and customers felt more comfortable visiting units. At the same time more existing tenants were holding onto their units for longer, even after many eviction moratoriums ended.
Transaction environment improves from early disruption.
The investment landscape for self-storage properties mirrored the operational changes of the sector in many respects. During the initial period of uncertainty, sales velocity slowed, both due to logistical limitations in closing trades as well as ambiguity over cash flows. As property performance stabilized and then improved, transaction activity similarly rebounded, with buyer competition adding upward pressure to the average sales price. Trading volume and pricing are well above previous economic cycles, even with current challenges, and the tight competition for assets is anticipated to continue.
Outlook for 2021 points to continued growth.
As a new year progresses, the self-storage sector is poised to ride several demand tailwinds. Remote learning and working are taking away storage space in the home, while businesses also must put aside excess items amid physical distancing. A relocation trend to less dense areas may also drive new storage use. However, elevated COVID-19 infections, renewed lockdowns and high unemployment may come to weigh on consumer demand.
Migration's Effect On Self-Storage
- The events of the past year have reinforced demographic trends that were already underway, chiefly the relocation of households from major gateway markets to more affordable destinations, often in the Sunbelt.
- As new residents arrive in states such as Arizona, Texas, the Carolinas and Florida, demand for self-storage increases. Moving is a common driver of self-storage renting in the short term, and a general rise in population will also improve storage needs over time.
- While the long-term demographic outlook warrants the overall increase in self-storage inventory, the rapid pace of deliveries had depressed asking rents until recently as operators of new facilities prioritized achieving high occupancy. Conversely, markets with low to negative net in-migration may record stronger rent performance because of minimal construction, as is the case in many California cities.
Household Consolidation, Campus Closure and Remote Work Leave Little Room For Home Storage
Following early disruptions, health crisis bolsters self-storage demand in key ways.
After the initial months of the pandemic when less population movement and historically high unemployment tempered self-storage move-ins, leasing activity improved. Easing restrictions and fiscal stimulus helped assuage consumers’ concerns, but storage facilities also recorded demand from households and businesses contending with new challenges posed by the health crisis. Businesses are also contending with capacity restrictions and other changes in consumer behavior that require them to reevaluate their space needs.
Household consolidation driving some self-storage leasing activity
Population growth and the corresponding formation of new households is generally associated with new self-storage demand. The health crisis may be disrupting this relationship. Since the onset of the pandemic, the rate of household formation has decreased. Yet, self-storage vacancy has continued to decline, even amid new supply. Self-storage leasing velocity may yet feel the impact of slower household formation, or the process itself could be adding to demand in a different way.
Students returning home due to campus closures bolster storage operations.
Self-storage demand received a boost in the spring of 2020 from college and university campus closures. The widespread shift to remote learning brought many students, as well as their belongings, home early. Self-storage properties normally see an increase in demand from student renters in the summer months, but the premature closures pushed those needs forward to the spring. The fact that many parents were also working from home only added to the need to store ancillary items. When fall semesters began, less than a third of college campuses were holding in-person classes as normal. A majority of schools were either continuing to focus on online instruction or practicing a hybrid model with only some students
Changing Business Practices Raise Storage Needs; Pandemic Behavior May Sway Demand Patterns
Capacity restrictions push restaurants, stores and offices to consider self-storage.
As with the consumer tenant base, the needs of commercial self-storage renters have also changed because of the coronavirus. Pre-health crisis, a wide range of businesses rented units, most often to keep paper records, excess inventory, and unneeded equipment and furniture. The widespread restrictions enforced at many places of business, especially bars, restaurants and other retailers, have accentuated some of these needs.
Shift with inventory management, shopping patterns to influence storage needs.
The widespread sequestration that took place in 2020 changed retail shopping patterns in ways that also impacted self-storage demand. First, inventory management practices changed. An initial wave of preparedness buying led to shortages of key necessities that pushed many retailers and distributors to shift from “just-in-time” inventory management to “just-in-case,” resulting in expanded inventories. Stores seeking an affordable alternative to expanding their retail footprint turned in some cases to self-storage facilities to keep the added stock.
A confluence of pandemic-related factors may disrupt normal seasonal trend.
Whether the renter is a private consumer or a business, the health crisis has had a profound impact on self-storage needs. The combined effects of the shift to remote working and learning, in addition to household consolidation and capacity restrictions on businesses, boosted self-storage occupancy to record levels last year. That trend is anticipated to continue in the first half of 2021 even though winter is a typically subdued period for self-storage leasing, with students back in school and fewer people moving. That was not the case this winter. More students were at home and many households may still relocate. The health crisis has shifted lifestyle preferences, with an emphasis on living in larger spaces away from high-density neighborhoods.
Health Crisis Recharacterizes Role of Technology and Automation Among Self-Storage Properties
Online rental platforms gain prominence during lockdowns.
The health crisis has shed new light on the prospect of technological innovation within the self-storage sector. When the country first entered lockdowns last spring, the digital tools that most benefited property owners were online rental platforms. Going into 2020, the most common method of finding a self-storage facility was from first-hand encounters while commuting, but online searches were the third most used method. The ability to not only locate a storage facility, but to rent and pay for a specific unit entirely online has become a structural component of the industry.
On-site automation tools take on new significance in pandemic environment.
The sudden need to avoid close personal interaction whenever possible added new value to many of the automation solutions taking hold in the sector. Beyond new safety procedures and cleaning protocols, applicable technologies include electronic locks and key-code accessible security systems that allow consumers 24-hour access to the facility and their unit.
New technologies may foster customer engagement post-pandemic.
Mobile smartphone integration is a growing practice in the self-storage sector. In addition to offering the same rental services as a website, these apps can be linked with on-site features such as smart locks to create a contact-less experience for the renter. Beyond the obvious safety benefits during the health crisis, these tools, when implemented well, can help differentiate a property for customers who value that type of user experience.
Technological innovation does not preclude success at older facilities.
Some of the recent automation tools adopted by self-storage owners are tied to newer facilities, but older properties have not fallen by the wayside during the pandemic either. Drive-up access to a unit is still a top requested feature among both private and commercial renters, and limits the kinds of personal interactions that can occur when sharing a common loading area or elevator.
Demographic Tailwinds and Migration Patterns Sustain Favorable Long-Term Outlook for Self-Storage
Millennial renter block bolsters long-term outlook of property type.
Since the last financial crisis, the millennial generation has emerged as an important pillar of the self-storage renter base, outnumbering every other generation in the self-storage renter pool. A decade ago most millennials were in their early 20s or younger, and the oldest of the cohort were not yet 30. As time advanced, more members of the generation finished school and left home to start new jobs. Many moved to dense urban areas where living space was at a premium, pushing some to rent nearby storage units. The nature of their living situations pushed them to access the units more frequently than past generations. In 2021, the leading edge of the cohort is almost 40. Many members of the generation have started families and moved out of the urban core, and they are now facing many of the same self-storage demand drivers that previous generations experienced. This aging has prompted a migration trend that has only been reinforced by the pandemic, with important long-term implications for the sector.
Migration to less costly, warmer climates underscored by lockdown environment.
Before the current health crisis, regional migration across the U.S. was already influencing self-storage performance. Households in search of lower costs of living and more temperate climates were relocating from parts of the West Coast and Northeast to the Sunbelt and Southwest. This in turn had increased renter demand and prompted additional construction activity in those settings. Markets that have led the nation in self-storage supply growth over the past five years, such as Austin, Charlotte, Nashville and Phoenix, have also seen their populations expand by multiple times that of the U.S. pace over that same span. The pandemic has only reinforced this trend, highlighting some of the drawbacks of living in a dense urban environment while simultaneously removing many of the benefits, such as being close to places of work or entertainment.
Anticipated downsizing trend fosters storage needs.
Another major demographic tailwind for the self-storage sector is the aging of the baby boomer generation. As the population of people over the age of 75 grows at an accelerated rate in the coming years, a wealth transfer is expected. An estimated 13 million to 14 million individuals are anticipated to leave the homeownership pool between 2026 and 2036, more than 40 percent above the 2009-2019 period. Numerous baby boomer households are likely to downsize, either out of preference or need, requiring them to either store or distribute many of their possessions and family heirlooms.
Health Crisis Constricts Development Pipeline; Vacancy Hits Multidecade Low
Coronavirus shutdowns temper construction activity.
One of the most notable effects of the health crisis on the self-storage sector has been with development. Temporary work stoppages and new safety procedures substantially slowed the pace of self-storage construction last year. Less than 14 million square feet of space was completed in the second quarter of 2020, the lowest quarterly delivery total since mid-2017. Arrivals picked up again in the September-to-October period but dropped to 12 million square feet for the final three months of the year. Total completions for 2020 reached 60 million square feet, down 14 percent from the year before and short of the record 70 million square feet deposited in 2018.
Certain markets take brunt of recent development wave.
Over the past five years, self-storage inventory in the U.S. has grown by nearly 20 percent, but space has not been distributed evenly across all markets. Metros that have experienced the most development since 2015 include Portland, Austin and Denver, where stock has swelled by over 35 percent. Raleigh, Nashville, Minneapolis-St. Paul, and Phoenix also had large pipelines. Much of the construction activity in these and other markets was driven by robust population growth that will facilitate new self-storage rental demand over time, but the brief period in which many of these properties opened challenged short-term leasing. Conversely, metros in California such as Riverside-San Bernardino, Sacramento, Los Angeles and the Bay Area have seen more modest inventory increases of less than 10 percent.
Most metros observed record-low vacancy last year.
Despite historically high development in recent years, the disruption to construction in the spring of 2020 paired with increased renter demand from the pandemic translated to falling vacancy in most major markets. Metros with comparatively few recent arrivals, such as Riverside-San Bernardino and the Bay Area, reported some of the tightest availability in the country at under 3.5 percent in the third quarter of 2020. Vacancy was similarly low in heavily developed Denver, as the area’s favorable migration trends, likely accelerated by the health crisis, caught up with new supply. Only a handful of major metros reported year-over-year vacancy increases. Las Vegas, which had the highest unemployment rate in the country at the time, reported a 20-basis-point annual vacancy increase in September to 5.8 percent. Availability also rose in Phoenix, where new supply growth remains a hurdle.
Asking Rents Recover From Health Crisis Distribution; Growth To Improve as Supply Pressure Dissipate
Asking rents recover from spring decline.
Entering 2020, multiple years of elevated construction had weighed on rent growth as operators leveraged lower asking rates to support occupancy. That dynamic became even more true in March and April when stay-at-home orders prompted fewer people to visit or lease storage units for a brief window. The average marketed rate for a standard 10-foot by 10-foot unit fell from $1.15 per square foot in February to $1.12 in May. However, as tenant turnover began to improve in the summer, asking rates rose, returning to $1.16 per square foot by the end of the third quarter, slightly up from a year prior.
Rent growth follows similar paths across unit types.
The performance of marketed rental rates through 2020 has been largely the same for climate controlled as well as non-climate-controlled units. Both types of rentals recorded rate drops in April and May, with the higher-cost climate-controlled space declining more steeply. The average asking rate for a climate-controlled 10-foot by 10-foot unit fell from $1.30 per square foot in March to $1.25 in May, a 3.8 percent drop.
Metros with less supply growth, strong in-migration post rent gains.
Following two consecutive years of falling asking rent at the national level, rent growth returned in 2020, led by several outperforming markets. These metros included Philadelphia, Los Angeles, Riverside-San Bernardino and Phoenix, where the average asking rates each improved by about 4.9 percent or more. A supply shortage contributed to the rent growth in Los Angeles while robust in-migration fostered demand in Phoenix, with rate hikes in the Riverside-San Bernardino resulting from a combination of those two factors. Southeast Florida, Sacramento and the San Francisco-Oakland area also recorded positive rent momentum year over year in December 2020.
Some markets still experiencing downward pressure on rents.
While the self-storage sector overall is continuing to benefit from many demand tailwinds spurred on by the health crisis, several markets still reported tepid growth in asking rates last year. These metros included Austin, Nashville, Dallas/Fort Worth and Denver, where averages all improved by 1 percent or less. The average asking rent declined in Minneapolis-St. Paul over the same span, down 3 percent. Although development slated for 2021 across several of these markets is more muted than in it has been in past years, new supply continues to be a lingering issue in those destinations.
Sales Velocity Recovering From Early-2020 Shock; Investment Landscape Broader Than In Past Cycles
Transactions continue through the pandemic.
While not immune to health crisis disruptions, self-storage sales velocity slowed by a smaller margin compared with other property types. Investment activity contracted by only about 10 percent between the first and second quarters of 2020, when physical distancing requirements and limited lender bandwidth delayed trades. Sales rebounded by more than 15 percent in the third quarter, however, as easing lockdowns led to more assets changing hands in that period than during the first 90 days of 2020.
Impact of the health crisis on sales varies by region.
The overall positive national sales trend was bolstered by some outperforming regions. During the second quarter, when strict lockdowns were in place in the Northeast and along the West Coast, roughly one in three self-storage transactions involved a facility in the Southeast. The Texas/Oklahoma region also recorded fairly consistent velocity throughout the year. Some other areas experienced greater slowdowns, however. Sales velocity decreased the most between the first and second quarters across the Midwest states.
Current investment environment well above previous downturn.
Despite new logistical hurdles, the number of properties traded in 2020 far exceed velocity from before the 2008-2009 financial crisis, reflecting greater investor demand. Buyer competition has contributed to a 57 percent increase in the average sale price since 2006, a phenomenon reflected in the positive returns of the public operators. Between 2009 and 2019, the equity value of the major self-storage REITs collectively improved by a wider margin than that of the S&P 500 or all REITs together. Similarly, the self-storage REITs posted a return of nearly 12 percent in 2020, whereas many other REITs ceded value.
Changing product mix an influence on but not the driver of higher sales prices.
Many of the self-storage facilities built over the past decade are fully enclosed, multilevel buildings with more climate-controlled units than older assets. These properties are also often located closer to population centers. These factors bolster the selling price of these buildings, which, as more of them enter the expanding buyer pool, has partly contributed to the substantial rise in sales values recorded over the past several years. Nevertheless, the majority of self-storage trades posted in recent years were still single-story buildings constructed prior to 2010.
Capital Sources Return to the Market After Interruption; Positive Fundamentals Point to Favorable 2021 Outlook
After pause, lending activity resumes with self-storage facilities holding advantage.
During the initial months of the health crisis when uncertainty was high, capital was limited. Many lenders stepped away from the market in the spring or became backlogged with servicing Paycheck Protection Program loans. Since June the capital markets have thawed, however, as more information about the economic damage of the pandemic on commercial real estate granted pricing clarity. This was particularly true of stabilized self-storage properties, which faced fewer disruptions to cash flows due in part to their essential status under lockdowns. Banks and credit unions, already prominent lenders in the property type, have taken on an even greater role in recent transactions as new CMBS issuance has been slow to resume. Interest rates on new debt are generally in the 3 to 4 percent range, with loan-to-value ratios below 70 percent. Life insurance companies are providing more conservative terms, while SBA-guaranteed loans can feature higher LTVs for experienced borrowers.
Capital sources become more cautious of recent or new construction.
The lending landscape differs notably for non-stabilized self-storage properties and projects under development. Given the historic level of construction that has taken place over the past five years, numerous newer properties are still in the process of achieving full occupancy. Spring and summer stay-at-home orders made that goal even harder to obtain. After a subsequent economic reopening period, spiking COVID-19 case counts in the final weeks of 2020 and early 2021 have led to an economic regression in some areas. Non-stabilized properties in danger of failing to meet loan performance expectations may turn to bridge lenders for short-term gap financing. Competition for these loans as well as the risks posed by the broader economic situation have prompted more stringent terms.
Investors face many favorable prospects and some hurdles in 2021.
Looking forward, the investment climate has significant potential. The Federal Reserve will likely keep the federal funds rate low for an extended period, holding interest rates well below the average first-year return on a self-storage asset. Strong property fundamentals also point to the stability of the asset class, which together with low lending rates reflects a compelling risk-adjusted return profile. At the same time, 2021 will not be without its challenges. The legacy of elevated development will continue to create pockets of concern in the sector. The ample increase in sales price over the past 10 years, while generally a positive for sellers, does raise the asset’s tax burden after appraisal. Various operating costs, including online advertising, continue to climb. Finally, the final outcome of the health crisis is still uncertain. While the ongoing disbursement of numerous vaccines improves the outlook, unforeseen challenges could arise that sway the recovery’s path.