Self Storage 1031 Investments: Maximizing Returns Through Strategic Exchanges

For many investors venturing into real estate for the first time, investing in residential property is the most straightforward and easy to understand. After all, most people have leased or owned a residential property at some point in their life, so they can grasp how residential buildings operate.

However, focusing solely on residential real estate means missing out on other, potentially more lucrative opportunities. self storage 1031 investments providing such opportunity in investing in self-storage, a booming asset class worth an estimated $48 billion and growing. What’s more, self-storage can be an excellent vehicle for a 1031 exchange, providing significant tax advantages. Let’s dive into what makes self-storage such an attractive investment and how it can be leveraged in a 1031 exchange.

Defining Self-Storage

Simply put, a self-storage facility is a space, usually subdivided into multiple units, that people can rent to store their belongings. The need for self-storage is vast, as people use these units for various purposes: to supplement their existing storage, store items during home renovations, for archiving and decluttering, during life transitions, or simply when they are on the move.

Self-storage properties are typically classified into three “classes”:

Class A Self-Storage: These facilities are relatively new (built within the last 10-15 years) and feature modern amenities like climate control. They are professionally managed, charge the highest rents, and usually have low vacancy rates. Class A self-storage is often located in prime areas and may include additional services like U-Haul rentals or UPS stores.

Class B Self-Storage: These properties are older (usually 15+ years old), well-maintained, but might lack 24/7 on-site management and have limited amenities. They generally charge average rents and cater to low- and middle-income earners. You’ll often find Class B facilities close to main roads, though not necessarily in prime locations.

Class C Self-Storage: These are older facilities located in less desirable areas (often off the beaten path). They have few amenities and limited security, charge the lowest rents, and often require significant improvements to generate a good return for investors.

There’s no single “best” class of self-storage. Each can be a worthwhile investment depending on your risk tolerance and business plan. I’ve seen value-add oriented sponsors turn Class B/C properties into facilities that compete with Class A over time.

Why Consider Self-Storage for a 1031 Exchange?

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows investors to defer capital gains taxes when they sell a property, provided they reinvest the proceeds into a “like-kind” property. Here’s why self-storage is an excellent candidate for a 1031 exchange:

Tax Deferral Benefits: By using a 1031 exchange to invest in self-storage, investors can defer paying capital gains taxes on the sale of their original property. This deferral can free up more capital to invest in higher-value properties, which can potentially yield better returns.

Diversification Opportunities: Self-storage investments offer a way to diversify your real estate portfolio. If you’ve previously invested in residential or commercial properties, self-storage can provide a new income stream that is less correlated with traditional real estate markets.

Recession Resilience: Self-storage facilities have shown resilience during economic downturns. When the economy is good, people buy more goods and need more storage. During recessions, people downsize and still need storage space. This dual demand makes self-storage a relatively stable investment.

Cash Flow Potential: Self-storage properties can generate strong cash flow due to their low maintenance costs and the ability to adjust rents quickly. Short-term leases allow for rent increases in response to market demand, and additional revenue streams can come from services like moving truck rentals or retail sales.

The Pros and Cons of Investing in Self-Storage Real Estate

Pros of Investing in Self-Storage

Low-Maintenance Asset: Thanks to advances in technology like lighting and security systems, self-storage facilities can be operated with relatively little supervision. The units are just core and shell, requiring minimal maintenance. There are usually few, if any, common areas to maintain, and landscaping is sparse. Among all real estate property types, self-storage is one of the easiest and most affordable to maintain.

Stable, Cash-Flowing Asset Class: Self-storage units can provide stable, consistent cash flow. The short-term leases make it easy to evict non-paying tenants and quickly re-lease the units. As demand increases, you can marginally increase rents, even by just a few dollars, since most tenants aren’t locked into long-term leases. Administrative fees, late fees, and retail sales can also boost cash flow.

Income Stream Diversification: Well-located self-storage facilities can offer additional products or services. For instance, facilities with significant land might offer covered outdoor storage, partner with companies like U-Haul for truck rentals, or even operate a fuel station or janitorial service on-site to diversify income streams.

Recession Resilience: Whether the economy is booming or in a downturn, the demand for self-storage remains strong. During good times, people move, renovate homes, and buy more goods, increasing demand for storage. During recessions, people downsize, move in with roommates, and sometimes face evictions, all of which also increase demand for storage. This makes self-storage a recession-resilient asset class.

Attractive Financing Options: Many self-storage owners also operate the business themselves, which makes financing for acquisition and improvements very attractive. Banks offer low loan-to-value, non-recourse loans, and SBA loans are another great option for owner-operators. These loans often come with interest-only periods to help lower costs while stabilizing the facility.

Cons of Investing in Self-Storage

Short-Term Leases: The month-to-month nature of self-storage leases can result in high turnover, requiring constant marketing to ensure units are quickly re-leased.

Potential Risk of Oversupply: Since self-storage facilities are relatively inexpensive to build, they can be quickly overbuilt during high-demand periods. Once demand tapers off, this oversupply can put downward pressure on rents. It’s important to consider both existing and planned competition within a certain radius before investing.

Demand Driven by Hyper-Local Conditions: A common mistake is investing in self-storage based on planned housing construction or demand from a local employer. If the planned housing units are never built or if the employer shuts down, demand can evaporate overnight. It’s essential to ensure there is sufficient existing demand that is diversified to safeguard your investment.

Not Entirely Hands-Off: While self-storage can be low-maintenance, it’s not entirely hands-off. Active management is necessary to ensure success, including ongoing repairs and maintenance. Having a strong business plan in place before purchasing is crucial.

Is Self-Storage Right for You?

Investing in self-storage offers many opportunities, especially with the highly fragmented nature of the industry. Many facilities are still owned by mom-and-pop operators who are on the verge of retirement, creating opportunities for those looking to enter the market with a more professional approach.

However, it’s not without risk. For those new to the industry, it might be wise to start by investing alongside an experienced sponsor who can maximize returns on your behalf, such as through a Delaware Statutory Trust (DST).

Are you ready to explore self-storage investment opportunities? Contact Perch Wealth today to learn how to get started.