What do we know about interest rates today? We know they’re very hard to predict in the short run. We know they’re currently at 42-year lows and have remained there longer than at any other time in the last century. We know low interest rates have a very positive (if not perfect) correlation to higher real estate values—the lower the rate, the higher the value. And we know, unfortunately, higher interest rates depress real estate prices. (See Graph 1.)
At the time of this writing, the Federal Reserve has raised the short-term rates for 10 months running and indicated that it intends to keep raising them until long-term rates go up. The Fed isn’t sure why, but the long-term rates (10 years or longer) have not gone up with short-term rates as they have in the past.
The only real reason to buy an income-producing property is the return, so value is directly related to the amount of revenue it generates. Other factors do come into play, but income makes up the lion’s share of a property’s worth. Cap rates are just a quick way of determining value.
A cap rate is the un-leveraged rate of return you can expect to earn on a property. A higher sales price produces a lower cap rate and is better for a seller, while a lower sales price produces a higher cap rate and is better for a buyer. The more a buyer pays for a property, the lower his return. For example, if a property’s income is $200,000 and it sells for $2 million, the cap rate is a 10 (the return is 10 percent). If it sells for $2.2 million, the cap rate is 9.1 (the return is 9.1 percent).
A word of caution: Some sellers in today’s market are using modified formulas to calculate lower cap rates, either out of ignorance or for more nefarious reasons. There is only one true way to calculate a cap rate, and that is to divide a property’s net operating income by its sales price. The main reason cap rates go up (prices go down) is because of competing investments in the marketplace. Today, cap rates range from a very rare 7 percent to 11 percent. The vast majority of properties fall into the 8.5 percent to 10 percent range.
The Virtues and Vices of Leverage
Most storage owners borrow money to buy a property. If the interest rate on the loan is below the cap rate, an owner has positive leverage, which simply means he is making profit off the lender’s money and his cash-on-cash return is higher. If the interest rate is greater than the cap rate, the owner gives up some of his return to help pay the interest on the loan. Think of it this way: If the lender takes less income in the form of interest, the property is worth more and vice versa. The blessing and the curse is the lender’s income is fixed and the owner’s income is not, making the latter more volatile.
A Peek Into the Future
While we know a lot about interest rates, cap rates and value connections, we’re not certain what this means for the future. Many storage owners are looking for a solution that will minimize their vulnerability to fluctuations in interest rates and value. As you begin your quest for the optimum strategy, ask yourself the following: How big is the risk vs. opportunity? What is the likelihood interest rates will change and by how much? What is the timing, and can you afford to wait?
Since cap rates rise with interest rates, we’ll use them as a proxy in the following example. Let’s see what a 2 percent change in rates would do to the value and equity of a hypothetical self-storage facility (2 percent is the average amount cap rates have dropped in the last two years). We’ll assume the following:
- The facility has a $1.88 million loan at 75 percent loan-to-value.
- Revenue is $300,000, and expenses are $100,000, leaving a net operating income of $200,000.
- The base cap rate is an 8. In reality, it might be higher or lower depending on the quality and location of the site.
As you can see by the change in value and, more important, equity, cap and interest rates are critical to an owner’s financial well-being. If they go up 2 percent, it’s unlikely the property could be refinanced for the amount of the current loan because it would not meet loan-to-value and debt-service coverage requirements. The situation is exacerbated because in times of rising interest rates, real estate markets become much less liquid (i.e., it’s harder to sell). Of course, if rates find new historic lows, the picture gets quite rosy.
What’s Going to Happen? What Should You Do?
That’s the $64 question! Think about your objectives. If you’re going to own your property for the next 10 or 20 years, you don’t have any serious concerns about overbuilding in your area, and you have locked down good financing, you don’t have to worry too much about interest or cap rates. But if you’re thinking about retiring or selling in the next three to five years, rates are going to be very important to you.
If rates go up and you have to sell at the wrong time, your equity could be substantially impaired. On the other hand, you could make a lot of additional profit if the rates continue to hit new lows and prices increase. If you take a chance and sell now, you’ll still capture the highest prices in 44 years. It’s a tough call. As the saying goes, “If you don’t bet the farm, you don’t lose the farm.”
In short, a long-term, well-financed holder is a lot less sensitive to changes in interest and cap rates. An owner with relatively “temporary” ownership, however, should consider whether the potential for short-term reductions and corresponding gains outweigh the possibility of increases and a resulting loss of value.
Give serious thought to whether you believe interest rates will go up or down. If you feel lost value could overshadow potential gain, act now. In my opinion, lower interest rates and a significant drop in cap rates seem less likely. You can bet the farm and find out.
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; visit www.self-storage.com.