The following Q&A was completed as part of our conversational Commercial Real Estate FAQ Interview Series, we hope you find it helpful.
When a new investor is getting to know a self storage investment firm getting to know their underwriting processes is really important. You’ll want the underwriting process to be conservative, as this allows for under promising but over delivering even if the numbers don’t look too impressive at first. Looking at these deals and investments with rose colored glasses can spell disappointment as you exit out of your deal.
Richard Wilson: What’s the number one smartest due diligence question a new investor could ask a self storage investment firm when getting to know them?
John Manes: That’s a great question. Probably the number one thing, probably try to understand how they underwrite. So, in self storage it’s an operating business, right? So, because of that I can plug in pie in the sky type of increases and so on, and get my numbers to work. So a lot of times you’ll hear “Well, I’m looking for a 18% or a 20% IRR or better.” Well I can plug anything into my model, and make it say 18 or 20%, – I mean, so? So, understanding how they underwrite. We, and this is to a fault, we underwrite from a conservative nature and a consistent nature from deal to deal based on operations and what we think we can do with that property, but we try to hedge in negative ways wherever we can. So if we know payroll for a store is $60,000 a year, we plug in 70. If we know that the late fee revenue average for that particular market is 3%, we plug in 2. So understanding how they underwrite to get to their numbers so that if they’re presenting you with a 16 IRR, are they going to overachieve that number or are they going to underachieve that number? In our case, I’d rather under promise and over deliver than vice versa. And that’s the – if I was an investor, that what I would want. If I’m going to give you my money, I would want to know how you underwrite. So I would ask, in storage, all different operational questions on how to underwrite. What they’re putting in into their underwriting model.
John: I’ll give you another great example. A lot of people talk about cap rates, and if you’re entering on a 6 cap, and you’re a 5 year exit, what are you exiting at? Well if I put into my model that I’m exiting at a 6 cap in 5 years, which probably is going to be the case based on how interest rates are going right now, then that’s not as conservative than if I exited at a 7 cap. And so if the interest rates stay the same, and I exit at a 6 cap, we’re all going to make more money, right? So understanding what numbers they plug into their model to get there – like a lot of people will buy on a 6 cap and exit on a 5 cap and their numbers look great. Well if you look at my model, I buy on a 6 and exit on a 7, and my numbers look okay, but I’m probably going to exit on a 6.
Richard: Right, right, yeah. It’s the true hallmark of an amateur when they have like really rosy estimates of everything across the board. Just makes you roll your eyes. Or like the last property that I acquired they were selling on a proforma cap rate, but I had to do the work. They were saying “Oh, no, it’s this, this is the cap rate.” Well, no, the current cap rate is so god awful you would never put it in writing, so proforma cap rate is not how you value something. So, yeah, that’s a great comment to make to avoid…
John: I found one today that is being sold, a storage property in Huntsville, Texas which is the kind of markets we like. We like secondary, and suburban, and some tertiary markets, and it’s more of a secondary market. And like we’re buying it anywhere from $40 a square foot to $70 a square foot in better markets than Huntsville, and they’re asking $88 a square foot and a 5.5 cap rate on the broker’s proforma. And I was like, “Huh?” So I was like “Overpriced!” and two, on the broker’s proforma? He doesn’t know how to operate these things.
Richard: Right. Right, right. We’re in the same situation right now in one asset, and I told my broker I was like “Well, the listing broker has got to sell and we don’t have to buy, so we’ll come back in a month and when he hasn’t sold it, then he won’t think we’re so crazy.” You know?
John: Right, exactly.