First, let’s consider the profile of a self-storage owner who can cash in on this opportunity. If you have one or more of the following, you are well-positioned:
- A variable-rate loan
- A construction loan coming due and a facility approaching stabilization
- A permanent loan coming due
- A permanent loan that has a high interest rate (7 percent or greater)
- Significant equity tied up in the business
- Another self-storage acquisition in mind
So what does this window look like? The background includes Greenspan’s measured approach toward increasing the Federal Funds rate. Never before has the Fed raised the rate in 10 straight meetings, taking it from 1 percent at the beginning of 2004 to 3.5 percent as of August 2005. By the time you read this article, it will be 11 meetings running. (See Graph 1.)
Graph 1: Fed Funds Rate Trend
Self-storage owners do not borrow based on the Fed Funds rate. Instead, they typically use the Prime rate and the 10-year Treasury yield. These follow the Fed Funds rate differently. If you were to compare graphs of the Prime and Fed Funds rates for the period of January 2004 to August 2005, you’d see an identical trend—they increase commensurately. However, if you compare the 10-year Treasury yield to the Prime rate for the same period, you’d see the former remaining relatively flat while the latter increased 63 percent. (See Graphs 2 and 3.)
Short vs. Long Term
Another way to look at this same divergence in rates is to compare the two-and 10-year Treasury yields over the same time frame. This is known as the “yield curve,” which typically reflects lower borrowing rates at the short end of the note period. (See Graph 4.)
The gap of only 12 basis points between the rates of the two- and 10-year yield in August 2005 causes most people to think the yield on the 10-year note is poised for an increase. Even as far back as February 2005, Greenspan was clearly puzzled by the divergence between the short-term interest rates and 10-year Treasury yield, calling it a “conundrum.” In July 2005, he delivered his most pointed warning that the low level of long-term interest rates is probably unsustainable.
What caused this unusual relationship between short- and long-term interest rates? There’s no simple answer. There are many variables such as the domestic money supply, Treasury-note purchases by countries such as China, and relatively low inflation. For no other reason than to keep things simple, I’m going to give credit to the Fed Funds management process. Greenspan has done two things that have positively contributed to record-low, long-term interest rates:
- He raised the Fed Funds rate as part of an effort to control price inflation.
- He has been very clear about his intent to raise rates in a measured manner, thereby preventing a panic about inflation.
How Long Will the Window Be Open?
The gap between short-term interest rates and the 10-year Treasury yield is the window of opportunity mentioned earlier. This is especially true for self-storage owners who are in a position to lock in long-term mortgage rates on their facilities. Of course, everyone wants to know what the rates are going to do, but no one really knows. There has been nothing in recent statements from policymakers to suggest the tightening cycle is over.
While there’s no real consensus on how much further the Fed Funds rate will be raised, the average estimate is an increase of 1.5 percentage points. Since the Prime rate tracks the Fed Funds rate plus 3 percent, that would put Prime at 8 percent by the end of 2006. It may not actually go that high, but my bet is it won’t be off the mark by more than .25 percent in either direction. The bottom line is, if you have a loan based on Prime, expect to see rapid increases in interest payments.
The more difficult questions are: What will happen to the 10-year Treasury yield in the coming moths? Will long-term rates continue to stay flat while short-term rates increase? The only reasonable conclusion is rates will soon start their move back to more “normal” levels.
But what is normal? Looking at the data provided in this article, you can attempt to surmise for yourself. The important thing to realize is we are in a unique phase in our economy with historically low, long-term interest rates. Moreover, this situation has created a real opportunity for self-storage owners to refinance their loans into 10-year fixed mortgages.
Bill Walton is a CPA and vice president of S&W Capital and Realty LLC, which specializes in arranging financing for self-storage owners nationwide. For more information or updates on interest-rate trends, call 704.371.4275; e-mail firstname.lastname@example.org; visit www.sandwgroup.com.
Finance Q & A
Q. My facility has not stabilized. Can I still convert my construction loan to a fixed-rate loan?
A.Yes, if you think you’ll be stabilized in the next six months. Your lender can help you obtain a forward rate lock that would allow you to fix your rate today and close up to six months later.
Q. I have a fixed-rate loan with a rate of more than 7 percent and a prepayment penalty. Can I convert this to a lower-interest, fixed-rate loan?
A.Just because you have a prepayment penalty, it doesn’t mean you can’t pay off the loan and refinance into a lower, fixed rate. Do the math. It may be worth paying a penalty if you can pull out some of your equity to invest in another opportunity.
Q. Will rising interest rates have an impact on self-storage values?
A.The consensus is when it becomes more expensive to finance acquisitions, cap rates will start to increase, resulting in overall lower values for self-storage owners.