The AAA Storage Podcast

Welcome to the AAA storage podcast,
your integrated real estate and

development partner, exploring all
things, self storage investing to

bring you diversified success.

Let's dive in.

Brandon Giella: Hello, Paul, and
welcome back to another episode

of the AAA Storage Podcast.

Today, we are going to get really
technical for our investors out there,

especially the quants who like to build
their own models and do their own due

diligence So the way we are titling
this episode and Paul, I need your help

to break this down, but we're titling
this understanding cap rates, yield

on cost development, spread, and IRR.

Paul Bennett: Yeah.

Brandon Giella: And so the point of
this conversation is that when you are

evaluating a property or project where
you're going to be investing, obviously

you guys and your team are doing your own
due diligence and trying to understand

exactly what the risk adjusted return
for the property, understanding the

performance and building out the models
to understand your profit on this project.

And so there's some key, You said
analytical tools that you do that for.

So you have these particular metrics
for analysis, but also the return on

the project overall, given what cap
rates in the market are going for.

And so help me understand if I'm a real
estate investor and I'm trying to assess

these projects that you guys have and
trying to, to understand how you're

thinking about the value of this project.

Where do I start?

Like, help me understand cap rates.

Help me understand how you guys
are thinking about yield on cost.

How you guys are thinking about, IRR.

Just, just help me like walk through
that a little bit to break this down

because I, and then at the end of the
episode, I hope we can kind of put

this all back together and, and get
a picture of, okay, this is how we're

determining the value of this property.

Paul Bennett: Yeah.

You know, I can't tell you how other folks
do it, but I can tell you how we do it.

We begin with the end in mind.

So ultimately, we're driven by
the internal rates of return that

we can provide our investors.

we've been able to perform
consistently at high levels on that

metric across our 30 year history.

it starts with cap rates.

Cap rates is a term, it's a
concept everybody's familiar with.

It's essentially the yield
that is provided by the

current net operating income.

of a property as a percentage of its cost.

And it's how properties are
valued in the marketplace.

we focus on two other metrics in
the analytic stage of a particular

project that are predictors of IRR
The first one is yield on cost.

And we'll break that
down maybe in a minute.

And the second one is development spread.

And yield on cost and development spread
basically give us the ability, once we

have a pro forma built out on a project,
and we've, we've done the cost estimates

so we know what the project is going
to cost, to predict what our profit

will be, and therefore what our end
terminal IRR to our investors will be.

And so, our current funds at 8, 000.

property portfolio fund to that will
launch, in Q2 will probably be at

least that if not 10 or 12 properties.

And those analytics are
applied individually to

each one of those projects.

And they sort of have to meet certain
hurdles, before we'll allow them to

be a part of a fund portfolio because
ultimately our objective is to drive

a 19 to 20 percent IRR time value
rate of return to our investors.

Brandon Giella: Beautiful.

Okay.

And this is, you guys have this track
record of doing this over the last 30

years, which is really, really impressive.

And so getting through these
hurdles are really key to it, to

understand if this property is
worth investing in, in a sense.

Paul Bennett: Yeah, it's, an analytic
ability to project or estimate future

profit from the development of a property.

And you could apply it in non development,
situations, particularly value add,

where you're buying a multifamily project
and spending some significant capital.

that would apply to any property,
but typically it's more of

a pure development analysis

Brandon Giella: Okay.

Great.

Well, let's walk through all
four of those components.

just so our listeners are understanding
kind of how we're working through it.

so we have cap rates Tell me about
cap rates and how you guys think about

them, but also generally in the market
I know this is a really common term.

I've heard that a lot but it's
capitalization rates on a property.

So tell me about that Okay,

Paul Bennett: love the analytical side
of our business, but cap rates are

simply the yield provided by the current
net operating income of a property.

And so when somebody says that apartments
in a certain market are trading at a

five cap or a 5 percent capitalization
rate, that means if you take the net

operating income of that property.

and divide it by 5%.

You'll get the market
value of that property.

I think what a lot of people don't think
about is why cap rates are what they are.

they are, first of all, the inverse
of multiples, which is used in

corporate finance for corporate
acquisitions and corporate transactions.

When people are buying companies, they
use a multiple of cash flow or EBITDA.

But one of the things that drive cap
rates up and down in any market and

in any property type is the likelihood
of the continuance of that cash flow.

So I'll give you a really broad example.

In the hotel industry, where your
tenant base turns over every night.

cap rates tend to be higher
than they do in a grocery store.

Grocery anchored shopping center
where your grocery anchor has a 25

year lease and all of your other shop
tenants have five to eight year leases.

the likelihood of the continuance
of the historical cash flow in

the grocery Anchorage Shopping
Center is a lot greater.

in a hotel and that doesn't apply
evenly and perfectly in all situations,

but it's People wonder why cap
rates go up and down, and that's

one of the reasons why they vary.

Interest rates also move cap rates
because they are essentially a yield.

If I buy a piece of real estate and
it's giving me a 6 percent yield,

or cap rate, it's bought based on a
6 percent cap rate, and treasuries

are providing a 10 percent yield.

the real estate investment doesn't
look very attractive at six.

that kind of dynamic will move cap
rates up, because you're always

thinking in terms of a risk adjusted
return with the treasury being

basically a zero risk instrument.

Interest rates move cap rates, the
dynamics of the property type, the

likelihood of the continuance of the
cash flow will move capitalization rates,

and then also market supply and demand.

We saw a phase in multifamily where
both on the operating side and on

the asset side, there was a real
imbalance between supply and demand.

There was a tremendous amount of
demand for apartments from tenants.

and a lack of supply, so it made the
development of apartments very attractive

or the purchase of apartments very
attractive and drove cap rates down,

at the same time, because there was
such a supply and demand imbalance,

there were more people that wanted to
buy apartments or develop apartments,

and so all of that together drove cap
rates, down, that in the multifamily

space, that trend has really kind of
reversed itself in the last 18 months

where there was so much supply created
that cap rates have gone the other way.

The seesaw swung the other
direction, but that's just sort of

an overview of cap rates, but they
are essentially used every day.

By every type of investor in real
estate because The value of a

piece of income producing real
estate is expressed in the cap rate

Brandon Giella: it's really helpful
that you mentioned, how you have

similar valuation metrics like if
you're valuing, an equity investment,

whether public equity or private equity
investment, where you might have cash

flow, return on cash flows or the
capital asset pricing model and beta.

And if you adjust those numbers, you
get a different kind of return picture.

And cap rates is kind of like that.

It's one of those numbers that you
would adjust on a model to understand

Paul Bennett: and the same dynamic
applies, I know we're not here to

talk about corporate finance But if
you look at two different types of

companies Let's say you've got one
company that has a subscription model

And so it has reoccurring revenue.

And maybe that revenue is tied to
contracts that are multi year contracts.

another company is transactional.

They have to resell their product or
service every day to every customer.

Let's say both of them Produce a million
dollars in net operating income or cash

flow on an annualized basis the company
with reoccurring cash with with the

MRR model the Reoccurring cash flow
model may trade at a ten times cash

flow or ten million dollars while the
transactional company May trade at a

five or six multiple So five or six
million the reason for that is the risk

of the continuance of the cash flow
when I've got long term contracts that

are 80 percent of my revenue a Buyer
can be fairly certain that cash flow is

going to continue for a period of time
at least to allow him to recoup his

original investment the transactional
guy Is a whole different model.

He's very sales intensive and there's
really no guarantee you'll have revenue

tomorrow and that same dynamic applies
to real estate long term leases but you

have to combine those in the real estate
world with the other dynamics supply and

demand and Interest rates and other things
that are driving cap rates, but it's

one of the factors that really impacts
how cap rates move in the marketplace

Brandon Giella: Okay.

Very helpful to understand that.

Thank you for that analogy.

So we've got cap rates and the next
one we've got is yield on cost.

Talk to me a little bit about that.

I know we've had an episode on that
where we touched it briefly, but, you

know, given this more full picture
about the quantitative analysis,

how do you look at yield on cost?

Paul Bennett: Yeah, yield on cost is,
to me, probably in combination with

development spread, but is probably the
most important metric as a real estate

developer and yield on cost is very
simply the proforma net operating income

of a property once it's stabilized.

So, again, that's based on some
assumptions, so your assumptions

have to be solid and reasonable.

But the pro forma net operating income
of a property as stated as a yield or

a percentage of its cost to construct.

So I'll give you an example, and
it's the example I think I gave

in the other episode when we were
talking about things related to this.

If it's going to cost me 10 million
to build a self storage facility.

And our proforma net income at
stabilization is 950, 000 annually.

That property has a nine and
a half percent yield on cost.

But it's also one of the big reasons why
we chose to really focus on self storage

and office industrial flex real estate.

If you look at the market in general,
across all property types, I would say

the vast majority of developers are very
comfortable with a yield on cost in the

seven to seven and a half percent range.

in self storage and in office industrial
flex, the way we build it, and the way we

manage it, Our portfolio yield on cost,
we shoot for a target of nine and a half.

and that's a pretty big difference
between 77 and a half and 99 and a half.

It's a 2 percent swing.

And I'll give you an example in a minute.

We talk about development spread, what
that means in terms of return or profit

margin in the development of a project.

But it's, it is, it is
the first indicator.

Of the premium return that can be
earned in exchange for the incremental

risk that comes with developing
versus buying a stabilized asset.

Brandon Giella: Yeah, I was
gonna ask maybe what is the

reason for that difference?

if seven and a half is, kind of
standard, but you shoot for nine

and a half, what makes up that
difference and why is that important?

Paul Bennett: well, part of the reason
is in our portfolio or in our situation.

we're pretty vertically integrated so we
can deliver cost of projects at a cost.

that is typically below what the
market costs for someone else to

build the same project would be.

So that's a little bit of an advantage.

Paul Shannon had a conversation
with him on another podcast and

he called it an unfair advantage.

I'll take that all day long.

But the other thing is the
nature of the product itself.

the relationship between rent rates per
square foot and cost to build storage and

office industrial flex is simply a wider
spread than it is in almost any other type

of real estate and just by its nature.

Let's be honest in a self-storage
facility where we're renting a

10x10 box with nothing in it and
we're getting 16 a square foot.

that same, piece of real
estate costs $100/ft to build.

so you take $16/ft take out your
expenses and you're down at a net

operating income level at, about $9.50/ft

in terms of your net operating income, so,
it's just, the product by its nature has a

higher yield on cost than office, retail,
multi family, all, all of those things,

and in addition to that, we can build
it a little bit less expensively than

most people, if you think about, I don't
know what apartment rents would be on a

square foot today, on a per square foot
basis, but, I'll give you this example.

everybody's familiar with a multi
story sort of fancy big box self

storage that's going up all over
the country, mostly in more urban

areas because land is so expensive.

We build single story
drive up self storage.

Those big box, I call them big
box locations, cost somewhere

around 160, 180 a foot to build.

Because they got elevators in them, they
have to have sprinklers, it's a whole

different product than the single story
drive up self stores that we built.

Brandon Giella: Mm-hmm

Paul Bennett: And they're all
climate controlled by the way.

100 percent of those buildings
are climate controlled.

but it cost them 150 to
180 a foot to build it.

I'm building it 100 a foot to 105 a foot.

But at the end of the day, they're getting
a small rent premium over us because it

may be an in town location and it may have
nice shrubbery outside it and, you know,

it's made of brick, not a metal building.

But the rent premium they're
getting doesn't overcome

the 60 to 70 a foot in cost.

That they have that I don't when
you calculate yield on cost.

So their yield on cost is coming in
at eight, eight and a half, and I'm at

nine and a quarter, nine and a half.

And I, that's not exact math, but it's
probably somewhere in that neighborhood.

Brandon Giella: Yeah.

Paul Bennett: If that makes any sense.

Brandon Giella: Yeah.

So seeing the larger picture from
an investor, from a developer's

perspective, you can see that, yes,
that might look super fancy on the

outside, but as an investment, it's
actually much better to do the single

story, drive up and not to say that the
single story drive ups don't look nice.

I mean, I know you guys, you know, make
all kinds of landscaping decisions, paint

decisions, things like that, but yeah.

Paul Bennett: Yeah, well, the other
thing, is everybody thinks those big

box stores are great until they've got
to unload their stuff, put it on the

cart, push it in an elevator, go up
three floors and push it down a hall.

I've been pushing our marketing
guys to do some billboards or some

advertising with a picture of a guy
like pinned against the wall by a

sofa, trying to jam it in an elevator
to get it up to his self storage unit.

Because the reality is everybody
would really prefer drive up where

they can back the truck up to the
door, open the door and basically

take two steps and put something down.

I think the single story drive up is a
better product at the end of the day.

But what justifies the multi story
buildings is if you're building

in, more urban areas where land
costs are extraordinarily high.

Then going vertical does make a ton of
sense, but I think, in a lot of cases,

single story drive ups a better product,
but that's a conversation for another day.

Brandon Giella: Yeah.

Now everybody knows the last thing you
want to do on moving day is have to go

upstairs and in elevators and all that.

It's all okay.

I love that.

You mentioned what, apartment or housing,
square footage around different areas

that at least I know in Fort Worth
here, Fort Worth, Texas, I think you

can get a good solid home at two 50 a
square foot or a good solid apartment.

So I don't know if that, that
tracks where, where you're at

in North Carolina, but that's

Paul Bennett: yeah, I just don't
know what rents are per square foot.

It varies so much by market,
but an apartment project cost

200, 280, 000 a unit to build.

if it's a thousand square foot unit.

You're talking about 280 to
300 a foot to construct it.

and I would say yield on cost
in multifamily is definitely

in the low sevens at best.

there's more appreciation.

you can grow value two ways.

cap rates can go up and down.

That can make the value of
your property go up and down.

You don't control cap rates.

the other thing you can do
is grow net operating income.

either by being able to raise
rents, or reduce expenses.

In most real estate, reducing expenses,
most real estate isn't super expense

intensive, so it really becomes about
driving, you know, increase in top

line revenue and therefore ultimately
bottom line net operating income.

the thing that multifamily does have
is lower yield on cost out of the gate,

You'll see projections that are
showing three, five, three, four, five

percent annual increases in rents.

And when expenses only increase at
one or two, you drive some significant

growth in NOI over a five, six,
seven, eight year holding period.

That translates into, you know, being able
to sell that property for significantly

more than you paid for it, down the road.

Brandon Giella: I'm smiling because
listeners should know this is like a

masterclass in real estate investing.

You're getting for free from an expert.

I just love listening to you because
I don't know this stuff very well.

You know, so to hear you like kind
of break it all down, it's like,

man, I could take this and just like.

I feel like I could just understand
so much more about real estate

investing because of you.

So, okay.

So we've got two more.

I want to get, I want to make sure
that we've got two more of these,

these, concepts is development spread.

And then how all that leads to IRR and
builds that fuller financial picture.

So talk to me about development
spread and how you think about it.

Hmm.

Paul Bennett: or it leverages off yield
on cost, and it's simply the difference

between your yield on cost and the
market cap rate for that product.

So, if I'm building self storage at a 9.5

yield on cost, and the market cap
rate for storage in that market is 6%.

My development spread is 3.5

or 350 basis points.

and it's, it's the one that begins to
really point to and reveal the return

potential of a particular project.

let's take a good apartment example.

An apartment project with a 7.

2 percent yield on cost.

So that means the proforma
net operating income of that

property is going to equal 7.

2 percent of what it costs to
build it on an annual basis

and a market cap rate of five.

That means they have a 2.

2 percent development spread.

There's a simple formula.

If you divide the yield on cost by
the market cap rate and subtract one,

you get the projected gross profit or
profit margin in the development of that

property if you sell it at stabilization.

And in that example, it's 44%.

If you take 7.

2, divide it by 5, and
subtract 1, you get 44%.

In storage, with a 9.

5 percent yield on cost, and market
cap rates at 6, so we've got a higher

yield on cost, but the cap rates that
value that property at stabilization

are higher too, which means lower
relative to the net operating income.

We have a 3.

5 percent or 350 basis
point, development spread.

If you divide 9.

5 by 6 and subtract 1, you get 58.

3%.

Brandon Giella: Hmm.

Paul Bennett: So the projected, you know,
the analytic answer to how much money

could this project make if we build it
on budget and we hit our pro forma net

operating income, the answer is 58.

3%.

This is my simple example.

we build a property for 10 million.

It has 950, 000 of cash flow, right?

Brandon Giella: Hmm.

Paul Bennett: That's a nine and
a half percent yield on cost.

We get it stabilized, and
we sell it at a six cap.

Brandon Giella: Okay.

Paul Bennett: If we've leveraged that
property, we put 30 percent of the cost

in equity, and 70 percent we barred from
the bank, which is typically what we do.

That means we had 3 million of
equity in that 10 million project.

We sell it for 16 million round numbers.

We pay off the bank their 7 million.

And we have 9 million left
that we send to the investors.

all of that driven by the yield on
cost and the development spread.

In that project.

And at the end of the day, if we give
our investors roughly back three times

their money and we do it in 55 and a
half years, that's a 20 percent hour.

Brandon Giella: Amazing.

Paul Bennett: that's the play that we run.

And we try.

It's like running in football.

It's like running off tackle.

It is just we just run it
and run it and run it again.

and that's really that's
in the simplest of ways.

That's the thought process and the
strategy that at Triple A we've built

Our business on and the ability to
consistently return in that 19 to

20 percent range on a internal rate
of return basis to our investors.

Brandon Giella: Amazing.

Okay.

I want to, this is a little bit of a
curve ball, but you guys have, I want to

emphasize, you guys have a track record of
doing this for decades across dozens and

dozens of deals, 90 completed projects.

I think it's the number.

so you have this pro forma that you
build before you go into a property

before you invest in a property and
you've got these numbers that you're

trying to hit and often you do clearly.

what happens during a project when you're
building or lease up that might throw

off that projection, if that makes sense.

is there something that you guys look
for to mitigate against during the

development of the project or during
lease up that you need to mitigate

when you're going through this process.

Paul Bennett: Yeah, we certainly, I
mean, projections, there's only one

thing I can tell you about every set
of projections that has ever been done.

It will not match reality.

Brandon Giella: Yes, right.

Paul Bennett: I mean,
nobody, is that perfect?

And certainly we're not.

a couple different answers.

I mean, first of all, obviously
we're driven by those numbers.

and so if we start to get cost
overruns in a project at that point,

you're pregnant, you can't stop.

then you have to look at
what the alternatives are.

can we drive the rates a little higher,
in the marketplace, you know, can we,

It rates and speed of
Lisa, which affects speed.

Disabilization are all interconnected.

So, you know, if things are humming
right at the right point, we may be

super aggressive with race to try to
lease it up faster to drive a little bit

higher time valued return if we're off.

point a little bit on cost, then we may
be a little bit less aggressive, except

a little bit longer lease up time.

But there are things that
are beyond our control.

If you hit rock when you start grading
the site and you got a blast rock

and it's going to cost a quarter of
a million dollars, I can't fix that.

Brandon Giella: Yeah.

Paul Bennett: And so the other answer
is it's why we started doing multi

property fund projects because out
of the eight projects in fund one.

I promise you will have one
that underperforms and at

least one that overperforms.

And at the end of the day, the blended
return across that portfolio will

meet that 19 to 20 percent target.

If you look at our history, we've
got projects that have been literally

had an hour are north of 1000%.

And our worst deal ever
had about a 2 percent IRR.

Um, if you were only invested in
that 2 percent deal, that, you

know, that doesn't feel as great.

Fortunately for us, most of
our investors have invested.

They created diversification.

Not via a fund vehicle, because
at that point in time, we were

doing single property syndications.

They created diversification by
investing in multiple projects with us.

So they might have been in the
2 percent deal, and they might

have been in one that did 40.

Um, but we, we, and that's
why we went to the fund store.

One of the reasons was to create a
little bit more consistent diversity

for investors, by putting a portfolio
together that spreads that risk of

projections being off, you know,
across more than one property, so.

Brandon Giella: Yeah.

Okay.

I love that.

Cause I, like I said, I know you guys have
been doing this for a long time, but what

they say is the map is not the territory.

When you get to the territory,
the map may or may not help you.

so I wanted to see how
you guys think through

Paul Bennett: Another reason why I'm
fairly negative, I guess, not really, I've

got some really close friends that are
developing multi story all climate control

storage and they're great guys, they're
smart, they've been super successful

and, you know, but I think I come across
a little bit negative on that product.

One of the reasons is the worst project
we ever did was a multi story project.

In Houston, Texas, and we fought our
way out of it and got all our money back

to our investors with a small return.

But it wasn't a pleasant experience.

And, I think that's another reason why
I just that product doesn't attract me.

Um, you know, fool me once.

Shame on you.

Fool me twice.

Shame on me.

So,

Brandon Giella: That's right.

That's right.

That's right.

No, you know what you like, you know
what you're good at and you stick to it.

And I love that.

Great.

Well, Paul, thank you so much.

This is seriously a masterclass
for those of you listening.

This is extremely useful information.

And so I highly recommend
taking notes during This episode

because it is that helpful.

Paul, you are an expert.

Appreciate you.

laying this out for us to understand
how you guys calculate your, your,

you know, the projects that you enter
into and help investors understand

what that looks like as well.

and so I'm excited to
keep going next time.

We're going to talk about the capital
stack as it relates to, different

investments that, or, or, you know,
capital allocation that you can

have, regarding your investment.

So Paul, uh, we're excited to meet
next time and I'll see you then.

Paul Bennett: Great, Brandon.

Thanks.