Self-storage owners interested in refinancing an existing or acquiring a new facility are always concerned with interest rates. Based on historical standards, today's rates are low. But is this an abnormal period of sustained low rates that will soon revert to the long-term “mean interest rate," or have we entered a “new norm,” where all-in rates of 4 percent to 6 percent will continue indefinitely?
Because interest rates are critical to the financeability and value of a self-storage property, it's important to have a sense of where rates are today relative to where they will be in the short and long term. Rather than opine on where I believe rates are headed, I'll present the facts and let you draw your own conclusions.
Limits to Borrowing
So what could happen to self-storage if interest rates increase? In a higher interest-rate environment, borrowers facing a refinance will be constrained in cash flow and value. As interest rates increase, cap rates increase, and self-storage values will almost certainly decrease.
Cap rates increase so investors can accommodate the new interest-rate environment while generating similar returns. However, because the self-storage real estate investment trusts (or other low-leverage buyers) can purchase with cash, the effect on interest rates may be tempered in markets where REITs compete. Secondary and tertiary markets will be more susceptible to changes in value due to increased interest rates.
With constant net cash flow and higher annual debt service thanks to higher interest rates, self-storage owners may be limited in terms of what they can borrow. In the example below, we assume that a 200 bps (basis points) increase in interest rate translates to a 150 bps increase in cap rate.
If inflationary pressure is causing rates to rise, this can sometimes work in a self-storage owner’s favor. Facility owners are well-equipped to respond in an inflationary environment by increasing rental rates accordingly. While it's true that expenses will likely increase at a similar rate, the bottom line net operating income should grow with inflation, helping to offset increases in cap rates and stabilize facility value.