Let’s not sugarcoat it: Capital markets are ugly and have been since September 2007 when the debt capital markets shut down. The bad news is the ugliness has persisted for three years. The good news is we’re closer to the end than the beginning.
In an article I published in 2006, I wrote, “In real estate, there always seems to be a disconnect between ‘uses of capital’ and ‘availability of capital.’ Currently, capital is readily available, but there is a shortage of desirable investment opportunities. The only sure thing is that prevailing conditions always change, and it is likely that there will be an abundance of investment opportunities but a dearth of capital, in the not-too-distant future, as a result of some unforeseen event that draws capital away from real estate.”
Little did I imagine how prescient that observation would be. Over the past three years, there’s clearly been a lack of capital, but there has also been a lack of investment opportunities. Lenders learned in the 1990s that once they took over properties, they experienced an additional 20 percent discount in pricing from vulture investors who understood the banks needed to liquidate assets quickly due to their lack of operational expertise.
Today, lenders have been reluctant to take back properties and decided to continue extending loans, hoping for a better day. This is better known as “pretend and extend.” Additionally, floating-rate loans, benchmarked to 40-year-low interest rates, have kept struggling real estate owners alive for the time being.
Access to Capital
Beginning in 2009 and continuing through 2016, approximately $2 trillion in commercial real estate debt will mature. While the debt side of commercial real estate has been held together with Duct tape, it too has it breaking point and we’re almost there. Lenders have significantly discounted real estate loans internally, and with the recent valuation rebound off the 2009 lows, once the banks are able to liquidate properties for a price higher than carrying value, they’ll be able to book a “profit,” which will result in markedly improved transaction volume. Soon opportunities will be on the horizon and access to capital will be critical.
Although focus is typically on cost of capital, we need to keep in mind that the lowest cost of capital is irrelevant if the going-in basis is wrong. If a property was purchased at the peak (2004 to 2007) with a 5 percent interest rate on the debt, even if zero percent interest rate debt was available, it wouldn’t make up for the 20 percent to 30 percent reduction in value. Availability of capital will be critical going forward—better to have the appropriate going-basis with a higher cost of capital that can be optimized over the next few years as capital markets recover.
The self-storage industry is experiencing its first real test since its beginnings in the early 1970s. At the time, the economy was in terrible shape, but self-storage was in its infancy and demand exceeded available supply; therefore, the deep recession didn’t have much impact on the sector.
With the evolution of self-storage and the amount of development experienced over the past 10 years, the industry is mature and experiencing its first true economic test. It’s a common belief that self-storage prospers in good and bad times. In good times, the population is more mobile, producing high utilization. On the flip side, when there’s an economic downturn, people downsize their homes. While they may part with their residences, they’re less inclined to part with their “stuff,” which bodes well for the industry.
Operationally, storage has experienced a numbers of peaks and valleys since the Great Recession began in 2008, and the industry has weathered the storm relatively well when compared to other real estate asset classes. In the office sector, when the giants fall, they fall hard (we aren’t quite there yet), and the retail sector is under demolished. The United States has 26 square feet per person of retail space while Europe has 2 square feet per person. That’s right―no typo. There could be some interesting conversion opportunities coming.
Lately, we’ve seen storage occupancies dip below 85 percent and, in some instances, dangerously close to 80 percent. Breakeven occupancy, inclusive of debt payments, is at 65 percent, so established properties are not in danger of defaulting on a cash-flow basis. However, the margin of error is becoming increasingly uncomfortable as consumers are reviewing personal expenditures as incomes decline. It’s important to monitor operating performance for signs of consumer weakness and to closely watch the net move-in/move-out ratios.