If a live frog is dropped into boiling water, he immediately leaps out of the pot. But if you put the frog in cold water and gradually heat it to the boiling point, he never thinks to jump. This experiment could be used as a metaphor for our failure to see how extraordinary the current times are in terms of interest rates and their impact on real estate values and returns.
There seems to be a general feeling that the interest-rate “pot” will never again boil and the prices of self-storage facilities have gone up just because they should. While I’m not certain if interest rates will rise (and even less sure when they might), I thought I would explore some of the history and evidence to see if we should join our amphibian friend and take some action before we’re cooked!
Laws of Physics
The effects of low and declining interest rates have had a dramatic impact on selfstorage investments over the last few years. As in physics, there are usually two equal and opposite reactions to all such changes. The most obvious result is owners get to keep a larger share of their hard-earned income by paying less to lenders. While this is a welcome and happy circumstance, it has had a subtle, opposite effect on the intermediate-term outlook for the industry: Developers see the cash-on-cash rates of return from self-storage and decide to build more projects.
For example, a project with a loan at 8.5 percent will produce a cash-on-cash return of about 9 percent to 10 percent; with a 6 percent loan, the same project will produce a return of about 15 percent to 16 percent. This increase will cause “visions of sugarplums” to dance in the heads of potential developers and likewise strike fear in the hearts of competing owners.
While the problem of overbuilding is not universal, there are some catastrophic results emerging. For example, one market I recently reviewed had had an average occupancy rate of 88 percent, but experienced an increase of 97 percent in supply in less than 18 months. In February, one operator told me that in a market in which he is active, the rate on a 10-by-10, climate-controlled space had declined from $145 to $89 a month, plus a free month, because of new competitors.
The other noticeable impact has been on the pricing of storage facilities in relation to their incomes. For each dollar of income a project produces, the amount a buyer is willing to pay increases. This is, of course, because the buyer will be able finance at lower rates and achieve higher returns. Using typical market rates (cap rates) for computing this increase in value, an average project would go up about 15 percent— even without increased operating income— largely because of the value created by falling interest rates.
The crowning glory is borrowers can get a larger loan because of this “double whammy” (lower interest rates and higher values). Low interest rates provide an almost perfect environment for anyone thinking of buying, selling or refinancing. While this sounds like a broker talking, let’s see if you agree:
- A buyer can purchase a great property and achieve a cash-on-cash return not seen in many years because of low interest rates. Looking back to our example, he can get a 50 percent increase in return compared to just three years ago.
- Sellers, on the other hand, can get the highest price per dollar of income in the entire history of self-storage.
- If an owner does not refinance and lock in a low interest rate for as long as he can, he needs more help than a new loan.
When to Make the Leap
If you are considering buying, selling or refinancing, the question is when to jump into action. Since we know the dramatic impact of interest rates, it might be useful to look at their recent history. The following chart is not a digital view of the Rocky Mountains but a look at the 40-year history of 10-year Treasury bonds.
Rates on the Treasury bond, plus a “spread,” are most often used to set pricing on self-storage loans. In the last 10 years, the spread has ranged from an additional 4 percent to the current all-time low of 1.5 percent. However, if you’re hoping for even lower interest rates, the following facts may demonstrate the risks of inaction:
- The Federal Reserve has indicated rates may go up in the future.
- The economy is growing, and interest rates increase in times of growth.
- Current rates are at their lowest in 43 years.
- There have been only four times in the last 40 years when rates fell between 2 percent and 4 percent: 1963, 2002, 2003 and this year.
- Over the last 40 years, rates were 3.5 times as likely to be in the 6 percent to 8 percent range as today, and equally likely to be in the 12 percent to 14 percent range.
- Overbuilding is a factor in many local markets.
- In a normal loan, each 2 percent increase in the interest rate has the same impact on cash flow after debt service as raising your operating costs 37 percent.
If you are contemplating buying, selling or refinancing, now is a great time to make the jump. The water may be about to warm up!
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.