Here’s the point: Interest expense and interest rates need to be managed and controlled just like any other expense. Don’t think of interest expense as “fixed” or “uncontrollable.” To that end, a better understanding of interest-rate trends (historical and expected) and their impact on your bottom line can help you better manage this task.
A number of different interest rates could be discussed here, but let’s focus on the two most commonly used by lenders to the selfstorage industry: the Prime rate, which is used primarily for variable rate construction lending; and the 10-year Treasury yield, which is used for long-term financing. Both fluctuate due to somewhat different factors and often produce differing trends—short- as well as long-term.
This article will examine these trends and provide a brief overview of what influences them. I will also provide a forecast for those of you who may be considering getting into the business, as well as those thinking about refinancing an existing loan.
The Prime Rate
The Prime rate is the interest rate charged by banks to their most credit-worthy and stable customers. Very few borrowers actually receive the Prime rate. The typical rate for a self-storage construction loan is Prime plus 1 percent (based on the borrower’s credit). In addition to construction loans, self-storage owners will occasionally obtain a Prime-rate loan as a form of “permanent” financing and will assume the risk of rate fluctuation.
The rate is almost always the same among major banks. Adjustments to the Prime rate are generally made by all of the banks at the same time. In recent history, the Prime rate has changed directionally as the Federal-Funds Rate (the rate charged on overnight loans between banks) has changed. In simple terms, the Federal Reserve Board lowers the Fed-Funds Rate during recessionary periods to help stimulate the economy, and raises the rate when it thinks there is concern for inflation.
The Prime-rate trend over the last 10 years shows we are (at the time of this writing) at 4 percent, after dropping over the last few years as the Federal Reserve Board lowered the Fed-Fund Rate in an attempt to stimulate the economy. It is interesting to note in June 2000, the Prime rate was at 9.5 percent and stayed at this rate for almost nine months.
For those self-storage owners who are currently borrowing funds using a variable-rate loan based on the Prime rate, the impact has been extremely positive to your interest-expense line. For example, if you had a $2 million loan at the December 2001 Prime rate plus 1 percent (or 6 percent) compared to the August 2003 Prime rate plus 1 percent (or 5 percent), you would be saving $1,130 per month when using a 20-year amortization schedule. However, the reverse— paying $1,130 more per month—could be true when you look at a forecast of the Prime rate out to the first quarter of 2005.
The Aug. 15 Prime-rate forecast, prepared by a major East Coast lending institution, Wachovia Corp., was developed by analyzing past trends and the underlying causes of those trends, then applying those economic models to the future. Because the forecast represents the average experience in the past, there is significant room for error.
A possible action point for self-storage owners is those of you who are currently financing your facility using a floating Prime-rate loan may want to consider refinancing and locking into a fixed-rate loan. Those of you who are considering entering the business should probably budget a higher interest expense for your construction loan to reflect the anticipated increase in rates.
The 10-Year Treasury Note
Interest rates on fixed-rate 10-year loans are priced relative to the yield on the 10-year Treasury Note. It is usually stated in terms of the 10-year Treasury yield plus a lender spread of X percentage points.
Unlike the Prime rate (and the Fed-Fund Rate), the Federal Reserve’s monetary policy does not have a significant impact on the Treasury yields. Instead, many complex economic factors can cause the rate to fluctuate. However, the primary drivers—especially over the last eight months—have been expected growth in the economy (gross domestic products) and expected inflation. The 10-year Treasury graph reflects a dramatic downward trend in the yield over the past 10 years. A graph on the last 20 years would reflect an even more dramatic downward trend.
Over the summer, I had a number of questions and concerns about the long-term interest-rate trends. While those few months were nothing more than a small blip in the chart, the trend is worth reviewing in a little more detail. The following graph shows a dramatic spike in the 10-year Treasury yield from its low in June 2003.
While the spike in this graph is definitely dramatic, it is not the real story. The real story is the drop in yield to the June 2003 low—and what happened to cause the rate to drop to its lowest point in more than 45 years. What are the primary reasons for the decline to June lows? There were a number of market technical factors, but the three primary reasons were:
- The continued reduction in the expectation of inflation.
- The overreaction to the perceived market risk of “deflation.”
- The belief that the Federal Reserve Board would use “unconventional” stimulus measures to keep long-term rates down.
While the fear of deflation was fashionable, it was really not a risk for the national economy. Also, the Fed reversed itself and ruled out the use of unconventional stimulus measures. The result, however, appears to have been a temporary “mis-pricing” of the 10-year Treasury yield. In other words, the recent jump in yield and long-term lending rates is more like a return to normal. The current trend is also starting to reflect signs of an economic recovery.
As with the Prime-rate forecast, the yield on the 10-year Treasury note is expected to rise. This forecast, also prepared by Wachovia, reflects the expected growth in gross domestic products and the expected rise in inflation as the economic recovery shifts into a higher gear. The recent rise in rates and the related forecast is not a surprise to some.
In an article in Forbes as far back as March 2003, it was noted that “Professionals overwhelmingly forecast a big move up in both long and short-term rates this year.” The forecasted rise is also not unreasonable when you compare the forecast to the historical trends over the past 10 years.
The impact in interest-rate trends over the last 10 years has been extremely positive for the self-storage owner in that long-term borrowing rates have trended down. But what about the future and the impact of the forecasted rate increase? When you do the math comparing the rate as of Aug. 27 to the forecasted rate of 5.8 percent by the first quarter of 2005, you see it reflects a 12.4 percent increase in debt service over that time period, using the assumptions in the following chart:
- A lender spread of 2 percent is used in the example. The actual spread a borrower obtains is based on many factors and can vary from this example by as much as plus or minus .5 percent.
- Assumes a 10-year loan using a 25-year amortization schedule.
If you currently have a variable-rate loan, or if you have been considering refinancing your current long-term loan to lock in a lower rate and improve your cash flow, a possible action point is to consider converting to a fixed-rate loan. Although the Prime rate is expected to stay flat until early 2004, the longer-term 10-year Treasury is already moving north. Overlaying the Prime-rate forecast onto the 10-year Treasury-yield forecast, the graph points out the timing differences in expected increases, with the Prime rate projected to exceed the 10-year Treasury yield in early 2005. An example of how this information might be used is reflected in the following graph.
The graph represents two different financing strategies. The first one reflects taking out a variable-rate loan at Prime plus 1 percent in the third quarter of 2003. The second assumes taking out a fixed-rate loan for the same amount and date at the forecasted 10-year Treasury yield plus 2 percent. (Remember the actual spread could vary by plus or minus .5 percent, depending on a number of factors.)
Using these assumptions, you see the interest rate on the variablerate loan is lower for the first five quarters, then exceeds the interest rate on the fixed-rate loan. With these historical interest-rate trends and the related forecasted trend, you can now evaluate the best financing alternative based on your personal needs and long-term financial strategy.
A variable-rate loan may be right for you, especially if you plan on paying it off in the next few years. Or knowing that the general consensus is short- and long-term rates are headed up, the timing may be right to obtain a fixed-rate loan and not take the risk of short-term rates rising back their levels of most of the last 10 years.
The above example considers only a few of the variables that should be taken into account when evaluating your financing strategy and managing your interest expense. Being aware of interest-rate trends (historical and expected) and understanding some of the key drivers behind the fluctuations will help you make better informed decisions about your financing strategy and ultimately give you better control of your interest expense.
Bill Walton is a CPA and a vice president of S & W Capital and Finance LLC. He specializes in arranging financing for owners in the selfstorage industry. For more information, call 704.371.4275 or e-mail firstname.lastname@example.org.