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Welcome to the Self-Storage University Podcast, where you will learn the correct way to identify, evaluate, negotiate, perform due diligence on, renegotiate, finance, turn-around and operate self-storage facilities. And your host is a partner in one of the largest real estate portfolios in the U.S. with nearly $1 billion of holdings, Frank Rolfe.
Making deals in the self storage industry is very difficult today. You have to navigate all kinds of issues. There's a lot of self storage facilities out there that are struggling. They're in markets that are massively overbuilt. They're seeing declining rents, they're seeing declining occupancy, but if you go farther out, you can find deals that do make economic sense. But still, often the seller wants more than it seemingly is worth, or there's risk on there that you just can't tolerate, and one good way to overcome these problems are earnouts and escrows. This is Frank Rolfe, the Self Storage University podcast. We're gonna talk about escrows and earnouts and what they are and how to achieve them and how they can help you in your creative deal making. Let's first start off with earnouts. Now, in an earnout, what you're doing is you're telling the seller, look, I don't think these numbers that you believe this facility can create are realistic. But I'm gonna go ahead and give you the benefit of the doubt, but you have to share the risk with me. Let's say, for example, somebody has a self storage facility that they want to sell, and they're wanting to use their occupancy from a year ago, which is much higher than it is today. You've had a lot of move outs. So they say, oh yeah, well, you can hit those numbers. I just lost my focus, I lost my attention.
I really wasn't into it that much, and then you can flip it and say, okay, well, the bank is only gonna go with what you have right now, and I can only really go with that. But I'll tell you what, if I can get the occupancy up to where you had it a year ago, then I'll go ahead and pay you that higher price, and we'll carry that in a title company, and we'll call that the earnout. So the earnout means that if they can attain a certain item, certain percent of occupancy, certain revenue level, then they get extra money. Now, why is that better than refusing? Because sometimes if you refuse to honor anything that the seller wants additionally, well, you can't get the deal forged. But what we're doing right now is we're gonna go ahead and flip it, and we're gonna make them have skin in the game. Now, one benefit of doing earnouts is it kind of lays bare the seller's true belief in the value. Because if someone doesn't believe it's attainable, they won't agree to it. If someone claims the thing can get back to 90% occupancy, but currently it's at 70%, and you say, well, then if it hits 90, I'll give you this extra money, and they say, oh, no, no, that's not gonna work, that's because they really don't believe it can hit 90%, right? So sometimes by doing earnouts, you kind of smoke them out of when they're basically lying to you. But you do have to pick out that unit to measure, and it has to be very specific.
To have an earnout, you would have to have an exact occupancy level, and you would have to say how that exact occupancy level is measured. And on top of that, you're gonna have to have a referee who can decide if that goal was met or not. Because the seller will always argue it was hit, and you'll always argue that it was not. So you're probably gonna have to get a title company involved, and they are gonna have to be designated the official referee to see whether or not you win or the seller wins. Now, of course, if you can hit the target, everyone wins, so that's not bad. Now, it's been our experience when you have earnouts that about 75% of the time, the seller loses. Rarely on earnouts do you ever hit the earnout. The earnout's kind of viewed by the seller as gravy. They just don't think it probably will happen, but it might, and that keeps them kind of happy until the time expires, but that's what an earnout is. It's a great way to get what sellers want without promising anything other than if you can hit those metrics, then they get the money. But then you have the other side of the equation, and on the other side, that's called an escrow. Now, an escrow is money that's held back at closing. Let's assume that there are some issues with the storage facility that you can't accept, that the lender can't accept. There's maybe a foundation problem, there's a roof problem, whatever the case may be. And the seller says, well, I can get that fixed a lot lower than what you're claiming it would be.
You say, okay, well then let's just go ahead and put that money in escrow, and if you can get that foundation fixed, we'll release it to you. But if you can't, we'll release it to me, and then I'll go get the foundation fixed. Once again, what we're doing is we're changing and we're giving the seller some skin in the game, because we're calling their bluff. They claim that you can do this or can't do that, and we're saying, okay, well, I hope that's true, but kind of under a trust but verify system, let's see if it happens. And if it happens, then you get it. Once again, this will rapidly expose the seller who is lying to you. So when the seller says, oh, there's no problem with the operating permit for this self storage facility, oh, okay, well then I guess you won't mind having an escrow to hold back until we actually get the thing from the city saying it's fine. And if they say, oh no, I can't do that, well, that's because they know that they're lying to you. So it's a great way to smoke people out. But just like the earnout side, you're still gonna have to have an exact metric, exact number in which you win or they win. And once again, we have to have a referee. And who's the best referee on that one? Once again, probably like a title company.
Now, we have found on the escrow side, the seller has a much better chance of winning than they do on the earnout side. Earnout side, they lose 75% of the time. The escrow side, they fail in their mission, they fail to hit whatever they were going to hit to get the money, probably about half the time. But either way you cut it, whether it's the earnout or the escrow, you're gonna win at least half the time or better. And that's why it's very, very important that you create these things and you create them very, very well. If you really want to do earnouts or escrows, you gotta use an attorney to write them up. Because when you have big money involved, the seller is always invariably going to try and refuse to admit defeat. Just like a politician who's poured millions and millions of dollars into their campaign and they just lost in the vote, what, they want a recount or they just don't believe it that they could have lost. So you have to have a structure, and it has to be written by an attorney, because that way we need to know that it's completely binding on both parties.
And as far as creativity goes, right now, as has long been the case, the good buyers, the smart buyers, the people who make money in self storage are the ones who are always thinking outside the box. Thinking outside the box on location, thinking outside the box on size. People who shun the old Public Storage concept of multi-story, urban, climate-controlled things that no one really wants, they really never did. They just want to pull up with their car or truck and just throw the things out the back into their unit and slam down the door and drive off. All these things that artificially people created in the industry that aren't really what consumers want. If you want to be a good deal maker, you have to go your own way, and you have to be extremely creative to get what you want and again, extremely creative to cover your downside. You gotta make sure that all of your risks are taken into account and you gotta mitigate those risks. And when it comes to mitigating risk and being creative, there are few things as effective as earnouts and escrows. This is Frank Rolfe, the Self Storage University podcast. Hope you enjoyed this. Talk to you again soon.