It’s time to sit up and take notice. The times have changed, and nobody seems to be setting up shop on Easy Street anymore.
It is abundantly clear that the so-called sub-prime mortgage debacle may be just the tip of the iceberg of problems in modern finance markets. Easy to obtain, cheap credit is the great lubricant that makes the engines of commerce really hum. Unfortunately these lubricating characteristics are the part of the formula that ultimately causes the credit system to break down.
Credit availability is largely a function of the lender’s confidence to be paid back with reasonable interest. Unfortunately, there are fewer institutions, or individuals, that find they have enough confidence in borrowers to lend money without what would have been significantly excessive guarantees or collateral just six months ago. One reason short-term Treasury Notes are yielding so little interest is that many investors are buying them just to preserve value because they can’t be sure that many of the traditional money funds, and the other so-called secure short-term investments, are not turning out to be secure and illiquid.
What About Wall Street?
We all remember Jimmy Stewart in It’s a Wonderful Life, the run on his little bank and what a pickle it put him in. Well, it is the same story today except that the bank is now the whole international financial system, and it appears to be in trouble because of lending unlikely to be paid back or having the collateral to cover the debt. Thank you, Wall Street, for inventing these "innovative" ways to create credit that appear to be safe, but manage to fail to be repaid just after Wall Street sells it.
You might ask how could we, as mere mortals, have known what was going on? There is an easy-to-read little book called, A Short History of Financial Euphoria, written in 1996 by John Kenneth Galbraith, the famous and witty economist. The book not only tells of similar events in history, but more important, tells how to identify the next wave of "euphoria."
Being in the self-storage business puts you square in the middle of the real estate business and, thus, the value of your property and the financing are ruled by the valuations imposed by the real estate world. For the last four or five years this arrangement has been absolutely terrific for self-storage owners as cap rates declined between 2.5 percent to 3.5 percent. (Remember, as cap rates decline, values go up; hence, the equation Income/Cap Rates = Value).
At the low end of the range, this means facility value went up by about 37 percent during that time without any increase in income. If you kept your old loan (assuming 75 percent leverage), your equity shot up by 127 percent. But the story still gets better. At the same time cap rates were dropping, interest rates on loans declined by about 3 percent, and the amount you could borrow went from 75 percent of value to 80 percent, possibly more if you included the benefits of substantially looser underwriting.