Three of the four publicly traded self-storage REITs are embracing a special type of development deal that enables them to assume less risk in expanding their portfolios.
In what’s called a “certificate of occupancy” deal, or “C/O” for short, a REIT agrees to buy a newly built facility from a developer. The developer assumes the financial burdens associated with buying land, securing entitlements and shepherding construction. The REIT then takes over the finished property from the developer.
This is an excellent way for us to continue to add in a market that we obviously really like.
— Chris Marr, president and CEO of CubeSmart
For REITs, the primary benefit of C/O deals is that they can leave the development costs off their balance sheets. Putting those costs on the books could harm the REITs’ financial performance.
Two of the REITs, CubeSmart and Extra Space Storage, recently reported that they each had three C/O deals in the works. Sovran Self Storage, the REIT that operates Uncle Bob’s Self Storage, recently bought a newly developed property in Chicago and is looking at three more C/O deals.
In its most recent earnings report, Public Storage didn’t mention any C/O deals. Rather, it’s been undertaking facility development on its own. The REIT has $240 million worth of development or expansion projects in its internal pipeline.
The local edge
It isn’t just REITs that are forging C/O deals with developers, but also large private operators, according to Marc Boorstein, principal at MJ Partners Real Estate Services.
“We are involved with half a dozen of them right now, about $400 million in total. We’re definitely having some private companies wanting to buy C/O deals,” Boorstein said.
Overall, he said, such deals are a small part of the market. Traditional developments and acquisitions still dominate.
Most of these deals are happening in high-demand markets where it’s difficult and time-consuming to find suitable sites for self-storage facilities and obtain the required entitlements, Boorstein said.
“[REITs] don’t have the development staff for that. In this case, the local developer has the advantage over the national company,” Boorstein said.
Local knowledge and connections allow developers to build faster than a REIT could with its own team. Boorstein said he expects the number of C/O deals to grow as the development cycle continues to heat up.
“It will grow, but it’s a small market,” he said. “It will be limited to only the best of the best locations and only well-qualified and capitalized developers that have done this before.”
The C/O deal isn’t a new invention; it’s been used by REITs since the 1980s. The recent surge in C/O deals merely represents a continuation of the trend.
Jeff Kinder, a self-storage consultant in Golden, CO, said these deals benefit the developer, also known as a merchant builder, and the buyer.
“The appeal to the developer is that they have an automatic exit. They know going in what their costs are, and they know what they can do,” Kinder said.
A REIT’s interest will be piqued if a developer can build a facility for less than it would cost to buy an existing facility in a certain market.
“With cap rates as low as they are now and pricing very expensive for existing facilities, the REITs are more than happy to encourage merchant builders to get out there and what they do best,” Kinder said.
David Toti, an analyst with investment bank Cantor Fitzgerald, said C/O deals insulate publicly traded storage operators from risk. Based on past experience, REITs hesitate to tackle development on a big scale, he said.
A decade ago, the publicly held storage operators had just completed a fresh round of development, but facilities took longer than expected to fill up.
“The recession came along and they were stuck with assets that took a long time to lease up, and that took a drag on earnings,” Toti said.
For a while, the REITs exited the development business, but now they’re warily pursuing development projects again, he said.
One of those REITs, CubeSmart, is underwriting its C/O deals based on a lease-up period of three years, according to President and CEO Chris Marr. CubeSmart says it’ll pay a total of $102.3 million for three C/O facilities now in its pipeline: Brooklyn, NY ($48.5 million), Dallas ($15.8 million) and Long Island City, NY ($38 million). The Long Island facility is scheduled to open soon. The two other facilities are supposed to be ready in the second quarter of 2015.
Marr said most remaining facilities that might come up for sale in the New York City market and certain other markets don’t meet CubeSmart’s acquisition criteria. C/O gives the REIT another expansion option.
“This is an excellent way for us to continue to add in a market that we obviously really like,” Marr said.
Marr said that if the new C/O facilities perform well, CubeSmart would look at boosting the number of C/O deals and relying on them as a “growth engine.”
No ‘full-blown development’
The three C/O deals in the pipeline at Extra Space are in Boston and Phoenix. Extra Space hasn’t disclosed the value of those projects, which are expected to be ready in 2015 and 2016. The company bought two ground-up developments during the first quarter of this year — one in Texas and the other in Connecticut.
Spencer Kirk, CEO of Extra Space, said that even though the pace of C/O deals is picking up, the REIT is “not going back into full-blown development.” Previous in-house developments have been a “drag” on earnings, he said.
Scott Stubbs, chief financial officer at Extra Space, said that with its lease-ups happening quickly, the REIT has gained confidence to enter C/O deals in markets where it already has a strong presence.
“We feel like any time you do a development property, you have entitlement, construction and lease-up risk. By doing it the way we’re doing it, you eliminate two of those three risks,” Stubbs said.