As investors stopped buying the pools in July 2007, the machine ground to a halt. Banks were forced to keep these loans on their books despite having no original intention of holding them on their balance sheets. Next came the “let’s figure out what we have here” process, and then the now-too-familiar multibillion-dollar write-downs as lenders question the net value of the paper.
So with that history, we can now examine how these market shifts have affected self-storage property valuations. The typical owner today may learn his facility has lost 8 percent to 10 percent of its market value. But what may be confounding is that simultaneously he has experienced increases in revenue and occupancy from the past year.
The reason for this seeming paradox has to do with the LTV ratio and the new DSCR. Prior to the credit crunch, a buyer could leverage a facility to 85 percent or, in some cases, 90 percent with a loan constant that either equaled the interest rate (based on a 10-year interest-only loan), or was only a fractional amount higher than the buyer’s quoted interest rate given the initial interest-only periods. If you adjust the required equity from 10/15 percent to 30/40 percent, and eliminate long interest-only periods, then the returns and available buyers will decrease.
Another problematic implication of the credit crunch is the immense perceptual disconnect we have today between buyers and sellers. Many owners still cling to a mindset of a 5 percent in-place cap rate. When they find that rate level is unachievable, they instead hold on to their fundamentally strong storage property because it is providing healthy cash flow. Combined with the fact that the self-storage asset class has such a low default rate (lowest of all types of commercial real estate assets), many owners realize they simply don’t need to sell right now, thus creating reduced deal flow in the broader transaction market.
As a result, we are now experiencing a property transaction market that is dramatically out of equilibrium and, in our opinion, will not return to normal levels until later this year.
The slippery slope with this phenomenon is that it creates a false perception that values have dropped dramatically. Our observations are that one-off asset sales have seen an 8 percent to 10 percent correction in market value at most, and that this decrease is due largely to the lack of available leverage, not the fundamentals of the operations.
However, for larger transactions that typically attract institutional capital with well-funded equity and in-place credit facilities, we have seen less than an 8 percent correction in market values. In these cases, the amount of capital trying to find its way into deals has not diminished. Rather, it is simply a timing issue as owners realize there will not be a snap-back to January 2007; thus, they are beginning to ground their expectations in the reality of 2008.