Surviving the Credit Crunch

Buyer demand for properties and self-storage development acquisitions remained strong. The reduced pricing in the capital markets introduced new, competitive buyers. Most had little to no experience but competed for self-storage acquisitions, which created more demand, increased prices and forced cap rates to compress significantly.

Today’s Landscape

Following the sub-prime debacle, we’re seeing a return to rational underwriting and investing standards. In addition, in what is now known as the “credit-crunch,” interest-rate spreads have increased significantly as risk is now being re-priced.

For example, consider a stabilized A-quality storage facility in a top-tier market. At the beginning of 2007, a 10-year, permanent, fixed-rate, non-recourse loan with a 30-year amortization schedule would have priced about 120 basis points over the 10-year U.S. Treasury yield (about 4.6 percent at the time), or about 5.8 percent for debt at 80 percent loan-to-value (LTV) with a minimum 1.2 debt-coverage ratio.

Today, that same loan would be about 75 percent LTV, and the interest-rate spread would be closer to 250 to 275 basis points above the 10-year U.S. Treasury (3.9 percent as of Dec. 1, 2007). As this article is being written, loan interest rates are close to 6.65 percent, approximately 1 percent higher than a year ago. The wildcard, however, is that spreads are volatile and shifting by as much as 20 basis points on any given day.

Much of the increased interest-rate spread has been favorably offset by a steep decline in the 10-year Treasury. Due to the lack of investor confidence in capital markets (from losses sustained from asset-backed securities), investors are steering clear of these assets, resulting in a drastically illiquid market and bleak economic outlook. Investors have been buying U.S. Treasuries in a “flight to quality” reaction, increasing demand, reducing overall yield and offering relief from sharp increase spreads.

In addition to interest-rate factors, lenders are pickier about underwriting criteria. In the past, they determined loan proceeds on as little as three months of net operating income (NOI); today, they place much greater emphasis on the trailing 12 months NOI. The same standards hold true for lenders’ evaluation of occupancies.

Lenders are placing heavy emphasis on asset quality, demographic outlook and cash equity in the deal. This means a property in lease-up may not be able to rely on recent occupancy and NOI increases alone to maximize loan proceeds.

Furthermore, when completing risk assessments, lenders are discriminating quality of projects as well as the competitive landscape. Lesser assets, or those within dubious markets, are likely to be perceived as risky, making it challenging to find financing. Debt for these assets will be more expensive and will lead to higher cap rates.

With the departure of aggressive debt capital from today’s markets, the greatest cap rate pressures will be felt in weaker assets and those in secondary and tertiary markets. Lenders are increasing under-writing standards and lending less, putting upward pressure on cap rates in these markets.