The End of an Era
By Michael L. McCune
No, not all of the Beatles are dead. But the handwriting is on the wall for the era of low interest rates. You may be asking, “What are the signs of impeding rise in the cost of borrowed money?”
- First, the Federal Reserve has raised rates consistently for more than four months, and it says it will continue to do so for some time.
- Interest rates are negative—in other words, lower than inflation. If the Fed wants to limit inflation, interest rates will have to go up.
- Interest rates are at their lowest point in 43 years, an extreme condition from an historical standpoint. It should also be mentioned the government ran spending in the hole this year to the tune of $450 billion, and that had to be borrowed. You can imagine what the rate would be if you put that on a credit card!
- Finally, the economy appears to be growing again, if only modestly, and that requires more credit for other purposes. This means rates will likely increase because of supply and demand.
Whoops! I almost forgot that by the time you read this, the elections will be over, and whoever wins won’t be trying to keep the rates down because he has four years until he has to answer to voters. In short, there is not a single credible indication that interest rates will go down over the next year and many reasons they will rise.
What Does This Mean for Self-Storage?
It means cap rates and interests are going up. Neither situation is good for self-storage owners or sellers and, frankly, much use to buyers, either. A rise in interest rates almost always means cap rates go up soon after, causing a decrease in the value of a property. (For a better explanation of cap rates, see my column in the November 2004 issue, titled “Cap Rates—A Mystery Unveiled.”) If interest rates are going to increase over an undetermined period of time, owners and prospective buyers need to do some serious thinking about their investment strategies.
Fortunately, they only have three options from which to choose: hold for the period, sell, or buy. The time to make a moneysaving decision is quickly approaching! While the choice is difficult, the cost of delay could be high, unless you have the luxury of waiting for the interest-rate cycle to return. Let’s see what we have to do to maximize our returns.
Buyers might think that with prices going down, they should wait to make a purchase. But when interest rates rise and prices fall, the cash-on-cash return decreases. Since a buyer is really purchasing cash flow and return on investment, in a period of rising rates, he ends up paying more in interest than he saves on price, and by a large margin. For example, a $1 million loan at 8.5 percent costs $480,000 more in interest over 25 years than a 6 percent loan, and the lion’s share of that interest is paid in the early years. In other words, a buyer has to get a giant discount to make up for a rise in interest rates.
Rates of return work the same way. A project that would have a 15 percent cash-on-cash return on a 6 percent loan would only yield a 9 percent return on an 8.5 percent loan. And don’t forget that because loan amounts are inversely tied to value and debt-service coverage, it is unlikely a buyer would be able to borrow as much with prevailing higher interest rates.
Even though prices are high, now is a good time to buy. Buyers waiting for high interest rates and lower prices are usually caught in a losing proposition. Remember, the seller doesn’t get the benefit of your loan, and that is where you get your increased cash flow. Sellers, make a note: If it is a good time to buy, it is a good time to find a buyer.
Should You Hold?
Self-storage is a good business with a long-term, bright future. If you are certain you want to stick with your current facility for the next five to 10 years, you are a “holder.” In this case, you must have a loan with a low interest rate or get one ASAP, otherwise your project may have trouble being competitive in difficult times.
Lock in a fixed interest rate for as long as possible, usually limited to 10 years. Playing around with variable interest rates in a rising market is a dangerous and tricky business. If you were that good at guessing rates, you would be on your yacht, not in the self-storage business! If you aren’t sure you’re a holder, read on.
Are You a Seller?
This is really a series of questions, because few people believe they are sellers until they seriously ask themselves about the future. Most owners love being in the self-storage business and believe in its possibilities. They don’t really like to think about selling. In the last decade, it didn’t matter if you thought about it, because anytime you wanted to sell, you could, and on fairly favorable terms.
With interest rates rising and the upward trend likely to last for some time, selling is going to become less profitable and more difficult. The math behind buying a property doesn’t work as well in a period of rising rates, which means there are fewer buyers and they have more leverage. Now is the time to decide if you are a seller, because the opportunities are going to change. To wait and sell at a later date could mean forgone profits or diminished price.
Let me describe what has happened over the last year because of falling cap rates. The roughly 1 percent drop (largely due to low interest rates) has increased the value of an average project by about 11 percent and the equity by a whopping 44 percent. This is without any improvement in net operating income. Unfortunately, this can also happen in reverse if interest and cap rates go up.
There are many reasons people want to sell their facilities, and many are uncontrollable. Some selling events include retirement, illness, desire to move, estate planning, divorce, need for cash, partnership breakup, a death in the family, an uncompetitive site, and overbuilding in an area. If you believe one of these reasons (or another) is likely to affect you in the next five years, consider selling now. If you wait to sell during the next period of rising rates, the terms, timing and price of the sale will be less favorable than those currently available.
The next few months are probably the last time for at least two or three years—or even longer—that we will have a sellers’ market. It will also be the last time you can be sure to control the timing of a sale and the value you receive. Now is the time to make a valuation for yourself.
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 1994, he created the Argus Self Storage Real Estate Network, now the nation’s largest network of independent commercial real estate brokers dedicated to buying and selling self-storage facilities. For more information, call 800.55.STORE or visit www.selfstorage.com.