Tighter underwriting standards and more expensive capital will flow through the real estate markets and clearly affect deal dynamics and investor profiles through cap rates and internal rates of return (IRRs). A cap rate is the ratio of an asset’s cash flow to its value; it’s a proxy used by investors to quickly compare yields on different assets. IRR is an alternative method that measures the true annual earnings on an investment over time by accounting for the time value of money. While cap rates and IRRs are not directly correlated, investors deploy both analytical measures when considering whether to purchase, sell or finance self-storage properties.
On our new playing field, the rules of engagement offer the harsh reality that lenders no longer give credit for projected cash-flow improvements and higher values at reversion. This forces investors to derive values based on cash flow in place and to bridge any debt gaps with more precious equity. Given this new rule, it seems reasonable that cap rates will widen by an amount sufficient to generate the IRRs investors require, as lower LTV ratios and the end of cap-rate compression will make it harder for projected IRRs to be met.
It’s widely expected that cap rates will widen by at least 30, and perhaps as much as 100 basis points, depending on the asset’s quality, location and performance. Cap-rate increases will conversely contribute to a decline in commercial property values.
What seems to be lost in all of the translation is investors have forgotten about the continual increase in value of their storage assets during the last five to 10 years when stabilized cap rates were lucky to be below double digits. While the market turmoil has not reached the double-digit level, it’s important to note that the pricing offered on deals today should still be historically attractive to investors who have owned their assets for more than five years.
Winners and Losers on the Field
Now that we’ve identified some of the playing-field changes and the new rules of engagement, let’s consider how they’ll impact market participants.
On the lending side, the benefactors will be life companies and commercial banks. Any financial institution with a healthy balance sheet and traditional “portfolio” lending platform that is not reliant on the capital markets to execute a loan sale is in a position to take immediate advantage in today’s marketplace. This is not to say that conduits will stop lending to self-storage owners; but market uncertainty and execution risk of their lending platforms certainly put conduit products at a disadvantage compared to life companies and banks. Accordingly, conduit volume is expected to drop significantly in the near term.