Falling Interest Rates:That's Good, Right? So Why Aren't We Smiling?

Falling Interest Rates:
That's Good, Right? So Why Aren't We Smiling?

The following is reprinted from the Argus Self Storage Sales Network Market Monitor newsletter.

Interest rates are at all-time lows, which is good if you're a consumer, but something odd is happening in the financial markets that is making the purchase of commercial real estate difficult. Investors that invest in the financing of real estate are getting a little concerned as they compare the risk they are assuming to the reward they are getting. If the stock market has been the focus of the nightly news of late, the bond market is where the real story is unfolding, and it is not encouraging for our business.

First, a brief primer on how most of the long-term lending gets done in self-storage today. Almost all of the long-term loans (five years and up) are generated by firms that package your loan with loans of other borrowers for all types of real estate, and sell them on Wall Street through a vehicle called commercial mortgage-backed securities (CMBS). Once your loan is combined with other loans in a large package (usually in the hundreds of millions of dollars) one of the Wall Street firms "chops" up the package into several tranches or parts--usually three--then sells them to investors. Each tranche represents a different level of risk based on the priority of the principle and interest payments coming from the entire pool of loans. Thus, the first level has the greatest security and the lowest return, the second tranche has more risk and a higher return, and the last tranche has the highest risk and possibly the highest return, but it is very speculative.

Going through all of these gyrations has made the whole package more attractive to investors and has generally broadened the investor market, which, in turn, has also made lending easier and cheaper for the borrower. The CMBS system has worked very well in recent years and has allowed great access to the credit market for all types of real estate, including self-storage.

Financing Going Up

So, if the system works so well, why are interest rates dropping while the cost of financing is going up? First, the stock market and the international financial situation have made investors, in general, very nervous. They are thinking, "Do I really want to lend my money at these low rates for such a long period of time?" Also contributing to the situation is the fact that the group of potential second-tranche investors has all but dried up because they believe that their level of security in the pool of loans does not justify the return. Another factor in this issue is that many of the packagers of these loans got caught with a large inventory of loans when the "music stopped" and lost a lot of money before they could sell their loans to Wall Street.

So, what now for the self-storage owner? Despite the fact that interest rates are going down, rates on self-storage loans are going up because the lenders are charging a larger spread (the difference between U.S. Treasury rates and loan rates) to help compensate for the perceived risk. The really bad news is that many of the lenders are simply pulling out of the market and waiting to see what happens. Generally, those lenders that remain will not lock up a rate until closing, and the underwriting process (i.e. loan review) will be tougher than ever.

Don't Wait

If you are currently thinking about getting a loan, do not wait. The general thinking among our friends in the financing business is that things are more likely to get worse before they get better. Likewise, if you are thinking about selling anytime in the near future and believe that your buyer may need a loan, now would be a good time to get started in the selling process. Since no one saw this coming, it is also clear that no one knows exactly what will happen in the future.

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