Low interest rates have been the best friend a self-storage owner could have over the last couple of years. It now appears the long, downward trend in interest rates has turned and is beginning to head upward. It was a great ride on the way down, and the relative value of today’s low rates remains—by almost any historic standard—extraordinary.
In the late spring and early summer, rates for real estate loans, including self-storage, were at 45-year lows. Many real estate investors have gone through very long careers and never experienced these kinds of rates. While predicting the future of interest rates is not a high-percentage game, it is safe to say that in the intermediate to long term, it would be reasonable for interest rates to trend upward.
Neal Gussis, our friend from Beacon Realty Capital Inc., has provided some interesting statistics to confirm a change in the rates has a high probability. For example, he has found the least interest rates have changed in any given year over the last 20 is 1 percent. He also allows that the recent change in the 10-Year Treasury Note was the fastest change of that magnitude in 60 years—the last was during the Second World War.
I recently heard the Federal Reserve Committee say it wasn’t dropping rates, but it “expected low rates into the future.” Unfortunately, this was met in the real estate marketplace by rates going up, with long-term rates leading the way. So, you might ask, “What do these actual and potential changes in interest rates mean for the average owner, buyer or seller?”
Impact on Owners
If you were fortunate enough to lock in a low fixed-rate loan while interest rates were at their recent lows, you are pretty smart—take a bow! If, on the other hand, you have a variable-rate loan, you have some difficult thinking ahead of you.
The question is when, or if, you should switch to a fixed-rate loan at a now higher rate. Several owners I have talked to say they don’t have to worry about fixing the rate because short-term rates will always be lower than the long-term ones. Having lived through the Carter Administration with the Prime Rate at 18 percent, I would just add that while it may not occur often, it really is devastating when it does.
There aren’t many real estate projects that work at those rates. There is a variety of solutions to the problem, including the purchase of interest-rate swaps, hedging in the commodities market or getting a new loan. Each has its own pitfalls and benefits, but none will work unless you take the action to initiate them. Two things are very important: 1) you need the best advice you possibly can find, and 2) make sure you really understand what your objectives are.
Impact on Buyers
Clearly, higher interest rates make any new deal less attractive than lower ones. Let’s take out the old calculator and see how much difference a change in the rates can make on an investment’s return. To save you the effort, I have computed the cash-on-cash returns on a deal that cost $2 million at a 10 cap rate, financed at 75 percent.
The return with a 5.25 percent interest rate was a whopping 20 percent, and with an 8.5 percent loan, the cash-on-cash return fell to 12.6 percent. It is the difference between getting rich overnight and getting rich in the long term. However, on the positive side, we may see more properties for sale as sellers recognize buyers take advantage of the remaining low rates. The smart sellers and buyers know low interest rates “subsidize” higher prices for the seller and higher returns for the buyer.
Impact on Sellers
Let me begin by saying you should not sell just because interest rates are going up; but if you are thinking about selling in the next year or two, your sale could be more profitable and easier to execute before interest rates go any higher. Combined with local areas of overbuilding that are occurring more frequently, this could be the right time to exit.
What change can a potential seller expect for trends in the selling market as interest rates trend up? First, cap rates that have been trending down will now trend up. When cap rates go up, the value of the property goes down in relation to its income. This is the result of buyers trying to achieve higher cash-on-cash returns. A one-point change in the cap rate roughly equals 10 percent of the value of the property.
Second, buyers become more critical of a property because they are less forgiving when the rate of return is 12.6 percent than at 20 percent, and they will likely have more options to choose from in the marketplace. The low interest rates have created a seller’s market that has lasted at least two years and continues today, albeit with some cracks beginning to appear.
Real estate values tend to be very cyclical, and it will be no different in the future; the only uncertainties are the volatility and the duration of the cycle. Some cycles are mild and some very difficult, but few last less than three years and some many more. Thus, if you have personal reasons to sell, please don’t wait for the trends to make your task harder. The axiom to remember is: Higher interest rates never increase values!
Michael L. McCune has been actively involved in commercial real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real estate consulting, brokerage and development company based in Denver. In January 1994, he created the Argus Self Storage Real Estate Network, now the nation’s largest network of independent commercial real estate brokers dedicated to the buying and selling of self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.