Real estate investing can be unpredictable. Especially in today’s turbulent market, attaining stability is about as probable as nailing gelatin to a wall. What’s an investor to do?
When market trends are stable, pro forma is achieved and forecasts are met, enabling investors to feel comfortable with their assets and investments. When stability is shaken, investing significantly slows; operators and investors scramble to identify new market drivers to improve an asset’s performance. The volatility of capital markets and the overall economy dominates today’s headlines, leaving investors and owners uncertain about the future of the real estate market.
One thing is certain: The real estate market is exiting an era of cap-rate compression, resulting in higher capital costs and increasing cap rates. No one knows how long this will last. Chances are we are entering a new cycle, characterized by higher debt capital costs, scrutinized credit and underwriting standards.
In many situations, new developments or properties in lease-up take longer to reach stabilization, due to weakening demographic and economic markets. How will these changes affect lending and investing so operators can remain aggressive?
A Little History
Looking back, it’s easy to see why cap rates compressed in the storage sector: because significantly low-cost equity, by historical standards, was readily available to self-storage REITs and private investors. A flood of new lenders created significant demand for real estate debt, and they became eager to compete for business by providing increasingly aggressive/ attractive debt terms.
Lenders captured business by lowering margins, increasing leverage made available to borrowers and reducing underwriting standards, such as lowering the required debt-service coverage ratios. Lending and investing in traditional real estate asset classes became extremely competitive, with what seemed to be a significant amount of capital chasing not enough deals. As a result, more lenders and investors turned to self-storage, an asset class recognized for its lower default rates when compared to other commercial real estate products (see Figure 1).