Surviving the Credit Crunch

Equity investors are also taking notice of the increasing cap-rate market when under-writing possible investments in self-storage and general real estate. An uncertain economy and employment growth is causing investors to re-evaluate criteria regarding rent and NOI growth, terminal cap rates, debt pricing and demographic trends. Simply put, conservative under-writing and higher borrowing costs will lead to lower investment returns.

The accompanying “Year in Review” is an example of how a self-storage investment may have performed in 2007. As seen, a $5 million self-storage investment made at the beginning of the year using 80 percent leverage at the then-current interest rate, assuming 4 percent NOI growth, yields an internal rate of return (IRR) of 21 percent. Assuming realistic investment standards, the IRR above 20 percent could easily generate interest from an equity investor.

Let’s evaluate a similar investment in today’s market using very realistic assumptions. With today’s available debt capital, a reduction of NOI growth to 3 percent, and an increase in the terminal cap rate to 7.5 percent based on the slowing economy, this investment only generates a return of 9 percent. This wouldn’t generate much interest from an equity investor or even a potential buyer.

Future Investing

Market uncertainty has negatively influenced the lending landscape. Aggressive lenders that were previously winning deals are scaling back or no longer providing loans. Many are finding that the illiquid securitized market is playing havoc on originations and they can’t appropriately price debt. This has caused many lenders to take a backseat while others have entered the market and competed for new debt business. Lenders still competing for debt business know they can command premium pricing for products and services.

Equity investors seeking diversified portfolios are still drawn to self-storage. Many believe prices will begin to stabilize and cap rates will rise because sellers will need to reduce sales-price expectation to close a deal.