Capital Markets And COVID-19: How Bad Will the Damage Be?

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When asked how coronavirus was affecting the self-storage industry, Neal Gussis didn’t have to think of an answer; he had already been ill during the pandemic. When Mini-Storage Messenger caught up with Gussis he was in recovery, but after three weeks he wasn’t completed healed. Gussis is the co-founding principal of CCM Commercial Mortgage in Chicago, where he provides mortgage brokerage and advisory services for commercial real estate with a specialty in self-storage.

Gussis considers himself lucky compared to others he knows in Chicago. “My wife’s co-worker lost her husband and her mother-in-law,” he said.

He also considers himself fortunate to be in the self-storage industry. “We certainly heard that self-storage was recession resistant, but we had no idea it could be pandemic resistant as well,” Gussis laughs. “I actually think the self-storage sector will come out of these tough times smelling like a rose.”

Gussis isn’t the only one to think optimistically. Investors did as well.

Using the pubic real estate investment trust market as a proxy, Chris Sonne, NKF’s executive vice president and specialty practice co-leader – self-storage, in Irvine, Calif., points out, as of the second week in April, self-storage was the third best performing REIT sector, down just nine percent (behind data centers and cell towers) as compared to the MSCI US REIT Index, which tumbled 28 percent and the S&P500, which deflated 18 percent. A report from NKF Self-Storage noted the stable performance was being driven by low capital expenditure needs, good operating margins, and steady demand, especially when compared to retail, office, and hospitality, where demand is nil at best.

As in the Great Financial Crisis from 2008 to 2010, the defensive characteristics of the sector benefits from disruption. Let’s take a peek at what that actually means.

An Operational Perspective
When the pandemic began to rapidly spread across America, and schools, universities, and businesses began to shut down, there was a rush to get self-storage space. Move-ins were on the rise because colleges let out early, adult children moved back home, workers now at home took over the empty rooms once used for storage, and even closed businesses needed to park inventory. That land rush slowed by the end of March, but most big operators would still say move-ins are positive.

March was very busy for Emeryville, Calif.-based Devon Self Storage, as monthly leasing impressively outperformed March 2019, reports Ken Nitzberg, chairman and CEO. “A lot of colleges closed in mid-March. Normally, the college season starts about May, when colleges normally let out. We experienced May in March this year. That was certainly part of the surge.”

Leasing at Devon slowed in April but not significantly.

Over at the William Warren Group, the Santa Monica-based self-storage management and development company, March was equally as good. “For the first few weeks when the virus began to take hold, move-ins were spiking quite high. The dislocations caused by the pandemic, offices shuttering, people moving into home offices, business closing or moving inventory, all substantially impacted self-storage, notes Gary Sugarman, COO of the William Warren Group.

Since the third week in March, that rush has slowed, “although there is still quite a bit of move-ins,” Sugarman adds. “We have a 24-hour call center operating remotely; business is still churning. As of the second week in April, it was answering 1,000 calls a day, and many of those end-up as move-ins.”

Not much different from Devon, which has seen a big uptick in online business.

All this must be balanced against move-outs, which are almost non-existent for one simple reason: With so many people and businesses under lockdown, residents can’t be on the street. “You don’t want to be out; you don’t want to be renting a truck or loading stuff, and if you move out, what are you going to do with that stuff?” Gussis asks.

Rents And Receivables
Same-store growth will be muted this year, and the magnitude of that is unknown, observes Sonne. The difficulty in predicting how profitable or unprofitable the industry in general will be is due to a number of basic factors, including industry rent levels, which are predicted to remain flat for the near term.

“No one is raising rents,” avers Aaron Swerdlin, vice chairman of Newmark Knight Frank in Houston. “Politically, you can’t do it; and in some places, legally you can’t do it. On top of that, you can’t foreclose on someone who can’t pay rent.”

Gussis adds, “Everyone is being over-cautious not to gouge rates, not to charge late fees, and not to hold auctions.”

The William Warren Group has temporarily suspended rate increases for its existing customers until it has a better sense of how the pandemic economy will eventually shake out. In addition, in certain states and municipalities, companies are restricted as to what can be done regarding asking rates. For example, in Hawaii, the state of emergency order prevents self-storage from increasing rates until the emergency is over. Some cities across the country have followed suit.

“Our rates are frozen or capped in some municipalities, but elsewhere we continue with our normal policies,” says Sugarman. “All our pricing is algorithmically determined on a unit-by-unit basis. When there is activity around a given unit size at a given location that price will go up because demand is robust. When there is no activity, price will stay flat or come down. Given the fact that we are in this unusual crisis, we are not necessarily reducing prices, but the algorithm is not necessarily increasing them either. Prices will remain steady until we get a better understanding of where we go from here.”

Devon has stopped all rental increases through the end of May, at which time it will make another determination after safely seeing how the economy is progressing.

“We are in 13 states and every city has a different order with the mayor, city council, state health officer, governor all issuing orders in regard to evictions, auctions, and rents, so we have to be very careful to keep up with all the proclamations coming out of each jurisdiction in which we have a store. In the end, we just decided to take a blanketed approach with no auctions or rent increases until at least the end of May or whenever restrictions are no longer in effect,” says Nitzberg.

In regard to all these proclamations coming from local jurisdictions, Nitzberg warns the devil’s in the details. In hard hit areas of the country, jurisdictions have imposed a moratorium on rents, be it apartments, commercial spaces, or even self-storage. That’s fine, but real estate owners all have mortgage holders that are expecting mortgage payments, and the county and school districts are not waving property tax bills.

“We will have a head-on collision if this goes much longer with people being unable to pay rents and property owners unable to pay mortgages and property taxes,” says Nitzberg. “All these people issuing proclamations are government employees who are getting a full paycheck.”

Customers being able to pay their self-storage lease so far has not been a concern, but there is a huge question mark ahead. The interesting thing about the self-storage industry is that monthly rental fees are miniscule compared to other commercial real estate sectors such as office, retail, or multi-family.

“When you think about it, the total monthly spent on self-storage is usually below most people’s bar bill or dollars spent at Starbucks,” jokes Sonne. Nevertheless, an early April NKF report noted, “In general, there has not been a free fall in rent collections like there has been in other sectors … delinquencies are a key metric to watch and operators will have to weigh the value of tenant retention and likelihood of future collection versus new customer acquisition.”

April is going to be close to normal for collections just because $110 or $220 a month is not an amount people are concerned about now. “However, we lost another 6.6 million jobs, so we will eventually be at over 20 million people filing first-time jobless claims,” says Swerdlin. “Many of those unemployed will [want] to shave expenses including self-storage rents. We don’t know how long this will last. May will be a much better indicator than April in terms of collections.”

If collections become a problem, then what happens with auctions, which are currently in a state of suspension throughout the industry?

“Accounts receivables have been going in the wrong direction since about the third week in March, but a significant component of that is the fact that we have suspended our auction activity,” says Sugarman. “Had we not suspended auctions, much of that inflation in accounts receivables would be solved by the auction process. We do expect accounts payables to be a challenge over the course of the coming months, but once we re-impose the auction process, we think we will be able to manage these down considerably.”

Transactions
Around the third week of March, Swerdlin’s group closed $170 million in deals. Then it was like a light switch was turned off and transactions everywhere went dark.

“It is difficult to transact right now for obvious reasons,” recaps Shawn Hill, a principal with The BSC Group in Chicago. “Not only has the cost and availability of capital changed as the lending markets adjust to new economic realities, but just the basics of transactions are difficult. It is almost impossible to get contractors on site to inspect assets and perform third due diligence because of quarantines, travel restrictions, and county court houses, title companies, and zoning offices are closed—all the things that we take for granted are extremely difficult right now.”

Devon had properties in escrow when the financial markets began to shut down, and now those acquisitions are on hold.

“We told the sellers, we need a 60- to 90-day extension because we are unable to send out our third-party vendors for due diligence,” says Nitzberg. “We have six properties under a Purchase and Sale Agreement, all of which have been extended indefinitely. The seller agreed because he knows he can’t sell to anyone else right now.”

This is a temporary situation and, since self-storage is still a desirable property type, Swerdlin expects the market will bounce back at least to 80 percent of normal fairly quickly.

“We got deals teed up with sellers who are not under any stress to have to sell immediately,” says Swerdlin. “When the transaction market is functional again, we are going to transact. Everyone is waiting for clarity on liquidity and asset pricing. The capital is there to do deals. There will be a 60- to 90-day pause, and then someone will pull the trigger, and everyone will follow.”

If buyers and sellers need to transact, they should get into the market as soon possible, as the process is likely to be protracted given the fact that active lenders are overwhelmed by loan requests, says Hill. Borrowers need to be prepared for slower response times given general business interruption and distracted employees who are dealing with various iterations of the quarantine.

Cap rates aren’t changing because interest rates have not changed much. Where differences would occur is in the underwriting. No one is expecting four percent to five percent growth rate over the next couple of years. Probably rent growth will be flat in the near term, although smart operators will produce incremental increases in net operating income.

“There are still many buyers who are interested in acquiring self-storage,” says Gussis. “These buyers have access to debt. And my gut says the cap rates for self-storage will be among the lowest of all property types. Some transactions that were in process have been extended.”

Gussis adds, the pandemic has been a “wake-up call” for small operators who don’t have the ability or patience for whatever the new world economy will end up being and some of those independent owners will opt to sell once the market is freed up again.

Financial Markets
There is so much happening in the financial markets it would take a real genius to sort it all out. Fortunately, the self-storage industry boasts some erudite players. Here are some quick observations from Shawn Hill and Neil Gussis:
 Banks generally remain well capitalized and healthy, largely as a result of lessons learned during the GFC. That said, things are evolving quickly, and bankers are drinking from a fire hose dealing with requests for forbearances, loan modifications, struggling companies, processing SBA relief loans, etc.
 Banks have a low cost of capital and rates are generally in the 3.25 percent to 4.5 percent range with 20- to 25-year amortization. Many banks will limit loan-to-value to 70 percent. Unless lower leveraged, banks will be recourse.
 Balance sheet lenders that are still lending are largely implementing rate floors or simply quoting an “all-in” rate on new loan originations.
 Many of the life companies and banks have implemented rate floors in the 3.75 percent range and up. Anecdotally, one very consistent lender had a rate floor on new deals last week of 3.65 percent. That has shifted up to four percent.
 Lenders are pulling back to a more conservative mindset and are focused on straightforward deals with solid fundamentals and sponsorship. This means lower LTV, higher debt service coverage ratio and debt yield metrics, and solid market and sponsor profiles.
 Many life companies and banks have temporarily exited the new originations market to wait for pricing clarity.
 The CMBS market has been disrupted and is generally in a stall. Most, if not all, CMBS lenders stopped quoting deals, waiting for the market to come back into focus. When CMBS starts up again, spreads will be higher, which will reflect the higher bond pricing.
 The bridge lending market was flooded with mortgage REITs, debt funds, and private money looking for yield. Prior to the crisis, bridge loans were being priced 250 bps to 450 bps over LIBOR on a non-recourse basis. The sizing of these loans was based on the lender’s underwritten stabilized cashflow. Many of these funds may not now have the access to capital or attractive capital to continue to provide bridge loans. At the same time, with more pricing pressures on lease-up deals, demand for bridge loans is likely to increase.
Up Ahead
To figure out where the self-storage market, if not the country, is heading, a lot of prognosticators look back to the Great Financial Crisis of 2008 to 2010.

“Banks now have a much more sophisticated understanding of the self-storage product type than they did after the GFC,” says Sugarman. “There was a lag before the banks began to finance self-storage. I don’t think we will experience the same lag. It will take time for the banks to get back in gear, but when they do, self-storage should be near the head of the line.”

NKF has its own comparison, noting banks are now in a much better position than in the GFC and the response from the Fed and government has been faster and larger this time. In addition, revenue management systems are vastly more prevalent now in the industry. NKF boldly predicts, “These differences, combined with historical performance even during the GFC … bolsters the consensus that the self-storage sector will be strong over the long run.”

Finally, a metaphor from Hill: “The GFC was like a tornado. You could see it coming, and a lot of the devastation happened rather quickly, and then it took years to clean up and repair the damage. This pandemic is more like an earthquake-caused tsunami. They warned us it was coming, but we were all standing on the beach looking out at the ocean and it was a beautiful day. Then the wave came in, and now the flood waters have hung around, and nobody really knows when the water is going to recede or just how bad the damage is going to be. Worse yet, they keep warning of aftershocks, so nobody really knows when it will be safe to leave the high ground, leaving us ambiguously paralyzed.”

 

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