Tapered Growth

Has The Industry’s Development Cycle Passed Its Peak?

The self-storage industry has been living in a fantasy world for the past few years, a kind of mercantile paradise where net income always climbed, buildings were fully occupied, the cost of capital was cheap, and lenders were tossing money at the industry as if marching in a ticker-tape parade.

What a difference a year makes. Live Oak Bank in Wilmington, N.C., a premier lender to the self-storage industry boasted its busiest year ever in 2017 with 91 self-storage loans. “This year is a little slower,” says Terry Campbell, general manager of the bank’s self-storage lending division. “We still see a lot of interest in the sector; we have a lot of leads, but fewer deals are working out.”

Things are no different along the Mississippi. Memphis-based Jernigan Capital, Inc., another niche self-storage lender, experienced its biggest year in 2017 with $410 million of on-balance-sheet financing. This year, says John Good, president and COO, is a transition year. That transition is downward as Good expects the company to do about $215 million of on-balance-sheet financing.

The problem for the self-storage industry is that the real world has come calling. Some of the news from our government and governing agencies has been good for the industry, a bit of it is neutral, but there’s also a lot that has been negative.

The good news is that the banks are healthy. The Federal Reserve’s stress testing earlier this year shows the country’s 35 biggest banks (including units of foreign banks with $50 billion or more in consolidated assets) are adequately capitalized and healthy enough to weather any economic difficulties in the near future. Healthy banks lend, and as Good points out, “There is a massive amount of loan demand, and we have had a lot of interest in refinancing the assets that were in development over the last three years.”

The economy has been healthy, perhaps too healthy, so the Federal Reserve earlier this year raised its benchmark interest rate while at the same time indicated it expects to hike rates three times this year. Now, there are a few problems for the self-storage industry with that trend line.

The least apparent effect is with the real estate investment trusts, including the self-storage REITs, which today own about 30 percent of the institutional quality self-storage product. When the Fed accelerates a rise in interest rates, as the Wall Street Journal states, the payouts on U.S. government bonds rise, making it competitive with REIT returns. REIT performance often moves in an opposite direction from interest rates. When the stock prices of REITs decline, the individual companies are less aggressive in the marketplace for new stores. Perhaps, one less well-capitalized buyer on that next deal?

The most obvious effect of rising interest rates is an increasing cost of capital.

“The cost of debt is going up,” says Shawn Hill, a principal at The BSC Group in Chicago. “We just had another Fed fund increase, with more on the horizon. Although that doesn’t directly apply to the cost of getting a mortgage there is a definite correlation. The 10-year Interest Rate Swap has come up and is above three percent for the first time in many years.”

Finally, the imposition of tariffs by the Trump administration, in particular the tariffs on steel and aluminum, has not been good for the self-storage industry because so much steel is used in the development of new stores. The White House dropped 25 percent tariffs on steel and 10 percent on aluminum; the result has been a surge in pricing, which is really smacking businesses that use the metals.

“Steel always is a cost of construction, and the cost is rising,” declares Jeff Bass, senior vice president and market manager for the National Self Storage Banking Group of TCF Bank in Denver.

“Steel is a major part of our business and will be until they start making units out of something else,” says Hill. “The boxes we build are primarily made of steel; the interior is still steel and the most recognizable aspect of self-storage, the roll-up door, is steel. And the cost of steel is going up. Tariffs and trade wars are not good for business.”

The Economics Of Development

One of the challenges facing developers in today’s self-storage market is the curiosity of lenders about market fundamentals and the impact on individual store economics. More than ever, it’s incumbent on investors to prove there is a healthy submarket in the area where a property is to be built. “Lenders will ask questions about the new supply coming in and what that will mean for rent and occupancy projections going forward,” says Hill.

Per Good, indications are that construction finance is going to be muted in the near future. “The reasons for are the lateness of the cycle and the public narrative over last 12 to 18 months there has been a concern about over-supply in big markets,” he says. “The banks have read the narrative and monitored it closely as they still remember what happened back in the financial crash 10 years ago.”

The basic question of supply and demand in any particular location is really just the new old-narrative. The new new-narrative is now the rising cost of development. Together the two “narratives” have suppressed construction loan originations by 50 percent over the past 12 months.

Steel is just part of the construction problem. The cost of all materials is rising; due the serendipitous economy, the cost of labor is higher; and good self-storage sites are peaking in prices as the general commercial real estate market hits the top of its cycle.

“We are doing construction and conversion deals, just less so this year than last,” says Bass. “A lot of it is because the terms of deals are changing.”

The primary roadblocks to underwriting deals, according to Bass are:

• The cost of developing a project, specifically in the top 40 markets, is rising.

• Interest rates have gone up. We have to underwrite and sensitize the project to higher interest rates versus two to three years ago. LIBOR has been as low as 0.3 percent and now it is about 2.1 percent. Most construction loans are done on a floating rate basis tied to LIBOR, and we are at almost two point increases during the last couple of years. It can be a hurdle, but the good news is we’re using creative solutions to get deals done.
  
  
• TCF Bank mostly finances projects in the top 40 markets and those are the popular spots with a lot of new supply. As new development depresses rental rates in the top 40, builders may have to be more planned and prudent in their approach.

Costs to construct are increasing because the price of materials are climbing, and the cost of funds are rising, reiterates Neal Gussis, a principal with CCM Commercial Mortgage LLC in Chicago. “The ability of the new project to make money will be the governor of whether construction will slow down–not solely due to supply and demand issues. We hear about projects being shelved because they don’t pencil out in the new world.”

The primary measurement that banks have used for the last several years for short-term, floating-rate loans has been LIBOR, which has moved up considerably.

“When I came to Jernigan Capital in June 2015, LIBOR was about 0.85 percent,” says Good. “LIBOR has more than doubled in three years to about two percent. For a construction loan from the middle of 2015, floating rate debt was about 3.25 percent to 3.5 percent and now is 4.5 percent to five percent–that level of rate increases produces a meaningful change in project cost.”

Good speculates some of those loans from 2015 are stressed, that debt service is under pressure, particularly if the construction loan was in a market with a lot of new supply.

Loan covenants kick in 18 months to two years after a facility opens.

“Developers who have missed projections on any one or more of prevailing interest rates, time of construction, lease-up pace, or rental rates are likely to experience pressure from construction loan covenants and/or impending maturity dates,” says Good.

The new phenomenon is that borrowers are trying to get off variable-rate loans and nail down fixed-rate loans, because the latter rates have barely moved up, says Gussis. “Although the indices for the five-year and 10-year Treasury have moved up, the spreads have come down. The overall rates in comparison to a year ago might be slightly higher but not significantly. If you are on a variable-rate loan, it will be beneficial to lock into a fixed rate loan.”

Technically, here’s what happening, explains Gussis: “What you hear from the economists is that the yield curve is flattening out, meaning the short-term rates are starting to approach long-term rates. What does that mean for borrowers? If you are a borrower who has a variable-rate loan based on LIBOR, the cost is moving up. If you have a construction loan which is based on an interest-only (IO), variable-rate, that construction loan has moved 1.5 percent in the past year. That could be costly.”

Here’s why. In a construction loan, the banks build in a reserve for operating deficits until the income covers expenses. The reserve will include space for interest-rate changes. For example, a new construction loan might establish a $300,000 to $500,000 reserve which gets drawn upon every month as the property stabilizes. Two negative things could happen. The property might not lease up at the velocity originally put into the proforma and projected interest rates rise more than expected. All those factors can make the reserve deteriorate faster. If that reserve deteriorates to the point where there is no reserve left, then the borrower has to come out of pocket to cover that shortfall.

Cap Rate Neutrality

Self-storage has been playing in that part of the cycle where cap rates have been decreasing, rents have been increasing, and fundamentals have been very strong. That paints a very good picture for the business because properties are worth more, investors are willing to pay more for the cash flow, and the property fundamentals are working in everyone’s favor.

“Now we’re moving to a different part of the cycle, where investors are willing to pay the same or maybe a little less for the cash flow as market fundamentals begin to be challenged, and, oh by the way, because of the impact of new supply coming in you can’t accurately project year-over-year or quarter-over-quarter income growth,” says Hill. “You should expect that income growth will probably be a little flat; even if you achieve CPI level income growth (about three percent a year), that’s probably going to be net-net flat because expenses will rise at the same percentage.”

If income is staying the same, relative to expenses, that’s not the end of the world. The impact of cap rates coming up has more to do with the disintermediation between buyers and sellers, avers Hill. “When you are in an environment where cap rates rise, usually what happens is it takes sellers a little while to adjust expectations and get their arms around the new lower offers. They go to market with one set of expectations and then when the offers come back they are disappointed because the offers are punk compared to what they thought they would be. It takes a little while for buyers and sellers to get on the same page and into the same spirit of deal-making.”

It can be difficult for investors to trend strong growth and lease-up because it’s not likely to continue, says Bass. “In many markets, rental rates are moderating; and if we experience a recession, rental rates depress further,” he adds.

There is only one way for cap rates to move and that’s up. Short-term rates have come up; long-term rates also have risen during the last year but not as much. “Interest rates can drive cap rates, but cap rates are more about potential ROI,” says Bass. “That return is driven by perceived risk. At present, there hasn’t been a lot of risk premium in the markets, but everyone is trying to think ahead.”

Lending Window Still Wide Open

Although caution is clearly the catchword of the day, for those in need, there is still plenty of lenders out there ready to keep the self-storage business operating at full throttle. For stabilized properties needing refinancing and other transactions that can use fixed-rate debt, the commercial mortgage-backed securities window is wide open.

For CMBS loans, the rates are very attractive, says Gussis. “You can do a 10-year CMBS loan fixed at under five percent. We are doing several CMBS loans because interest rates are still low,” he says. “The difference today versus a year ago was that the CMBS loans were priced equal if not higher than bank debt. The market has moved again where CMBS is cheaper than bank debt.”

CMBS not only offers good interest rates right now, but one can also get IO periods ranging from a couple of years to full-term IO if the leverage points are low enough, in the 60 percent LTV range.

A wide variety of lenders are emphasizing bridge loans such as TCF Bank. “One of the solutions that is working for our customers is bridge lending. A bridge loan is not necessarily a permanent loan but is meant to get you from point A to point B,” says Bass. “We’ll do bridge loans that can start with three- to five-year terms and then add extensions. The way we look at bridge loans is they can be opportunistic or value-add.”

Finally, the SBA has been very active. “We finance new construction and acquisitions,” says Campbell. “We can do refinancing, but right now folks can get a better deal with their local lender.”

Typically, if someone is coming to Live Oak Bank either for new construction or acquisition, they are coming because they don’t have the normal amount of equity that a conventional lender wants, usually 25 percent to 35 percent equity, says Campbell. “We can do it for as little as 10 percent equity. We are OK with that because we understand the industry. A lot of local banks don’t understand the industry. That’s all our team does, and we do it in every state.”

Steve Bergsman is an author, journalist, and columnist. His stories have appeared in over 100 newspapers, magazines, newsletters, and wire services around the globe; his most recent book is “The Death of Johnny Ace”.