Capital-market volatility during the past 12 months has significantly changed the landscape for self-storage real estate investing and financing. If you have applied for a loan in the past eight to 10 months, you’ve likely noticed these changes firsthand.
Gone are the days of 85 percent to 90 percent loan-to-value ratios (LTV), 10-year interest-only periods, and 1.05 to 1.10 debt service coverage ratios (DSCR). As a result, more attention than ever is being focused on the intricacies of valuation underwriting.
As real estate investment and financing advisors, one of the issues we’re viewing on the street these days is that many property owners and investors are unaware—or more appropriately stated, in a state of denial—of how these new capital market realities will affect their financing and refinancing loan requests. Unfortunately, they became so accustomed to generous loan-program provisions and aggressive valuations from past years they’re having a difficult time adjusting to the current landscape.
If you understand why lending programs and valuations are in the state they are today, then you’ll be better prepared to capitalize on current market conditions to help meet your investment goals.
Behind the Scenes: Market Shifts
The amount of deal volume in today’s self-storage market compared to a year ago is very different. From 2005 to mid-2007, it seemed each passing week brought a new buyer, another portfolio transaction, or a new fund looking to invest in self-storage properties. Meanwhile, deals in all commercial property types were trading at a record pace.
Owners, developers and long-term property holders became sellers, given the valuations that self-storage assets were achieving nationwide. In most cases, these owners and investors met or exceeded their initial projected investment returns within one or two years, as opposed to a more traditional five-year hold time. Things were great and everyone was content ... and then came the correction in the securitized debt market.
Prior to mid-2007, the commercial mortgage backed security (CMBS) market was a well-oiled, fast-moving and efficient machine. Loans were issued by capital sources, pooled together, and then sold to a foreign buyer, pension fund or institutional investor at record pace.
As investors stopped buying the pools in July 2007, the machine ground to a halt. Banks were forced to keep these loans on their books despite having no original intention of holding them on their balance sheets. Next came the “let’s figure out what we have here” process, and then the now-too-familiar multibillion-dollar write-downs as lenders question the net value of the paper.
So with that history, we can now examine how these market shifts have affected self-storage property valuations. The typical owner today may learn his facility has lost 8 percent to 10 percent of its market value. But what may be confounding is that simultaneously he has experienced increases in revenue and occupancy from the past year.
The reason for this seeming paradox has to do with the LTV ratio and the new DSCR. Prior to the credit crunch, a buyer could leverage a facility to 85 percent or, in some cases, 90 percent with a loan constant that either equaled the interest rate (based on a 10-year interest-only loan), or was only a fractional amount higher than the buyer’s quoted interest rate given the initial interest-only periods. If you adjust the required equity from 10/15 percent to 30/40 percent, and eliminate long interest-only periods, then the returns and available buyers will decrease.
Another problematic implication of the credit crunch is the immense perceptual disconnect we have today between buyers and sellers. Many owners still cling to a mindset of a 5 percent in-place cap rate. When they find that rate level is unachievable, they instead hold on to their fundamentally strong storage property because it is providing healthy cash flow. Combined with the fact that the self-storage asset class has such a low default rate (lowest of all types of commercial real estate assets), many owners realize they simply don’t need to sell right now, thus creating reduced deal flow in the broader transaction market.
As a result, we are now experiencing a property transaction market that is dramatically out of equilibrium and, in our opinion, will not return to normal levels until later this year.
The slippery slope with this phenomenon is that it creates a false perception that values have dropped dramatically. Our observations are that one-off asset sales have seen an 8 percent to 10 percent correction in market value at most, and that this decrease is due largely to the lack of available leverage, not the fundamentals of the operations.
However, for larger transactions that typically attract institutional capital with well-funded equity and in-place credit facilities, we have seen less than an 8 percent correction in market values. In these cases, the amount of capital trying to find its way into deals has not diminished. Rather, it is simply a timing issue as owners realize there will not be a snap-back to January 2007; thus, they are beginning to ground their expectations in the reality of 2008.
In recent years, our industry became extraordinarily attractive to developers who would have traditionally focused on other commercial real estate types. They were intrigued by the notion that self-storage is an easy asset to manage—or so they thought. Correspondingly, we experienced a development cycle of huge facilities ranging from 120,000 to, in some cases, more than 150,000 net rentable square feet.
A statistic from the Self Storage Association bears witness to this development boom: “It took the self-storage industry more than 25 years to build its first billion square feet of space; it added the second billion square feet in just eight years (1998-2005).”
Many newly developed facilities are still on their constructions loans, so permanent debt will need to be placed on these properties. Given today’s new market realities, these developers will need to contribute a significant amount of equity in order to receive a permanent loan, but with the industry’s generally strong performance, these loans will be attainable. However, the cash-outs certainly will be fewer and far between.
Where We Are
We believe overall values for self-storage assets have corrected by as much as 10 percent from its 2007 first quarter peak. With maturing construction loans, maturing floating rate debt (originated in 2006) and maturing CMBS debt (originated in 1999 and in 2003), this correction is likely to remain static through 2008 as the market absorbs these deals.
With all of the media hype over write-downs and commercial real estate woes, we expect to see “distress sales” within the self-storage industry appear on a very limited basis. Maturing construction loans are likely the most vulnerable, but there simply is not enough volume from that market segment to create a systemic effect across the industry.
Any deal priced after August 2007 likely has a majority of the credit market correction priced into it. Therefore, late-2007 closings, along with those closing this year, are establishing new benchmarks and comparables that will help narrow the current seller-buyer delta by fueling volume.
The overriding sentiment today is that cash flow is king. Sure, buyers are willing to allocate some value to upside in rents and/or occupancy, but only when a facility is measurably below market in rents or is newer and has space left to lease. The main focus in today’s valuation matrix is on in-place cash flow. Buyers will be extremely aggressive on what is there today because it is a known quantity with history to back it up.
Doug McCarron is a managing director at HFF Self Storage, formerly Storage Investment Advisors, and can be reached at 310.908.4728 or [email protected]. Devin Huber serves as senior vice president with Beacon Realty Capital and can be reached at 312.207.8232 or [email protected].