Rising Interest Rates And Rougher Financing Tides
Another year, another year for which to be thankful.
As 2018 ends, we can be thankful the self-storage industry enjoyed yet another year of growth, increasing income, and higher property valuations that were fueled by strong occupancies, year-over-year revenue increases, record investor demand, and an abundance of debt options at low interest rates.
But don’t get too comfortable.
Competitive forces will become more significant given the new supply of storage facilities. Further, the cost of capital is on the rise as we move into 2019.
To stay competitive and ahead of the game in the coming year, storage owners and managers will need to be smarter when it comes to managing their finances and operations. If not, they may be wishing it were 2018 all over again.
Interest Rates Are Rising
We saw the initial signs of rising interest rates in mid-2018, and they’ll likely continue to increase in 2019.
Until early 2018, the U.S. economy was humming along with the lowest unemployment levels in nearly 50 years and the stock market roared into record territory. But good things never last forever. Volatility and doubt crept into the markets in the third and fourth quarters, which are signs we’re in the late innings or, perhaps, extra innings, of this economic expansion.
Signs of a healthy economy are precursors for interest rates returning to more normalized (that is, historically higher) levels. It’s likely that 2019 will witness continued upward interest rate movement.
Lenders base mortgage interest rates on a spread over various indices. The 30-Day Libor and the Prime rate historically correlate to Fed Funds Target Rate movement. In addition to multiple quarter percent rate increases in 2018, the Fed has already indicated that more interest rate bumps are on the horizon in the new year. So, as the Fed continues with incremental bumps, you’ll see lending rates move accordingly. These indices have increased by approximately one percent during the past year and a total of two percent in the past three years.
Short- and long-term Treasury yields are based on many factors and are not linear relative to Fed Funds Target Rate adjustments. Over a one- and three-year period, the five-year Treasury yield increased by approximately 1.1 percent and 1.65 percent respectively, and the 10-year Treasury increased by 0.8 percent and 1.05 percent during that same timespan. Shorter-duration bond rates have increased at a faster clip than longer-term bond options.
Thus, we are inching closer to a flattening yield curve in which short-term loans pay interest rates equal to, or even above, longer-term loans. While rising indices mean mortgage rates are rising, spreads have slightly decreased. This has softened the increase in resulting mortgage interest rates.
Many variable rate loans tied to Prime and Libor that previously had lower overall interest rates compared to five- or 10-year fixed rate loans, are now actually higher and will continue to climb as the Fed further increases the target rate. Nearly all construction loans are variable rate-based and will be affected by these changes.
Higher Interest Rates Cap Off Loan Proceeds
Let’s bring all this interest rate movement into a real-world perspective for storage owners.
Higher interest rates cause debt service payments to increase, which results in additional stress on the debt service coverage (DSC) in your loan agreements. What this means is your ability to maximize loan proceeds actually decreases because a minimum DSC is needed to meet lender requirements.
This is particularly applicable in markets where storage properties are valued on lower cap rates. For example, buyers seeking 75 percent loan-to-value leverage will likely need to commit greater equity for their next storage purchase in 2019.
According to U.S. Census data, a record $9.39 billion was invested in self-storage properties from January 2016 to August 2018. Union Realtime reports that during the same period, 1,858 facilities opened nationwide.
Despite recent development and construction surges, self-storage remains a micro-market industry and it’s impossible to categorically state that an entire metropolitan statistical area or market, for example, is overbuilt.
Given pent-up consumer demand, many storage projects leased up quicker than projected during the past few years. However, as we get further into this development cycle, lease-up is now taking longer than expected and requiring discounted introductory rates in order to attract renters.
In many cases, the lead time for finding a site, planning, entitlement, and permitting is quite lengthy. And as we experience a market shift, project assumptions from, say, 24 months ago are likely remarkably different today in relation to construction and financing costs, lease-up rates, and lease-up projections.
When developers review proformas for storage construction projects slated to come out of the ground in 2019, they simply may no longer pencil out when it comes to attaining anticipated returns on investment, which translates into some projects never getting underway.
However, it’s not all doom and gloom on the construction side.
Many lenders will continue to provide construction financing for new projects in 2019. Key for them will be the sponsor’s strength and experience, as well as the development’s feasibility and underlying economics. No two lenders will underwrite a deal exactly the same, but a commonality is they will underwrite the project if they feel there is a strong possibility of take-out or permanent financing at stabilization, whether it’s with them or another lender.
Financing Existing Facilities
Your financing ability may or may not be affected by local market dynamics. An existing storage property’s historical performance is the primary determinant for a loan amount and terms. Lenders also take into consideration new competitors and ones slated to open soon. If new competition has put downward pressure on street rental rates and monthly revenues, lenders will likely be less aggressive with loan proceeds.
The new year brings storage financing challenges, but that doesn’t mean your hands are tied. These challenges can be overcome using a multi-pronged approach.
For starters, your management approaches have to stay relevant and competitive. This means re-evaluating the way you manage your business in order to capitalize upon state-of-the industry advancements. For example, you may decide to join a group like Storelocal, which provides a platform of sophisticated shared resources among owners, or perhaps you consider switching to a third-party management option for your properties.
Another tool is to use financing to your advantage. With interest rates inching up and new supply market pressures affecting so many locales nationwide, you could, for example:
- Look to switch from variable-rate financing to a fixed-rate option, or
- Refinance sooner rather than later so that you lock in a lower interest rate and maximize loan proceeds.
And if you’re in a new construction situation, you can re-evaluate development economics for projects in the pipeline so that you err on the side of being conservative given shifting market conditions.
The tide in 2019 will be rougher than recent years, but it will still be high from historical perspectives. Self-storage will continue to be a sought-after asset class with plenty of capital providers and investors aggressively seeking lending and investment opportunities.
Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.”
The tide is not out, but you should embrace the challenges of the times.
With nearly 30 years of experience as a national self-storage mortgage broker and advisor, Neal Gussis is a principal at CCM Commercial Mortgage, where he specializes in securing debt and equity for self-storage owners nationwide. He can be reached at (224) 938-9419 or ngussis@CCMfinancing.com.