Real estate investing can be unpredictable. Especially in todays turbulent market, attaining stability is about as probable as nailing gelatin to a wall. Whats an investor to do?
When market trends are stable, pro forma is achieved and forecasts are met, enabling investors to feel comfortable with their assets and investments. When stability is shaken, investing significantly slows; operators and investors scramble to identify new market drivers to improve an assets performance. The volatility of capital markets and the overall economy dominates todays headlines, leaving investors and owners uncertain about the future of the real estate market.
One thing is certain: The real estate market is exiting an era of cap-rate compression, resulting in higher capital costs and increasing cap rates. No one knows how long this will last. Chances are we are entering a new cycle, characterized by higher debt capital costs, scrutinized credit and underwriting standards.
In many situations, new developments or properties in lease-up take longer to reach stabilization, due to weakening demographic and economic markets. How will these changes affect lending and investing so operators can remain aggressive?
A Little History
Looking back, its easy to see why cap rates compressed in the storage sector: because significantly low-cost equity, by historical standards, was readily available to self-storage REITs and private investors. A flood of new lenders created significant demand for real estate debt, and they became eager to compete for business by providing increasingly aggressive/ attractive debt terms.
Lenders captured business by lowering margins, increasing leverage made available to borrowers and reducing underwriting standards, such as lowering the required debt-service coverage ratios. Lending and investing in traditional real estate asset classes became extremely competitive, with what seemed to be a significant amount of capital chasing not enough deals. As a result, more lenders and investors turned to self-storage, an asset class recognized for its lower default rates when compared to other commercial real estate products (see Figure 1).
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.
Following the sub-prime debacle, were 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 todays 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.
Impact on Investor Criteria
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.
Lets evaluate a similar investment in todays market using very realistic assumptions. With todays 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 wouldnt generate much interest from an equity investor or even a potential buyer.
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 cant 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.
Navigating the Storm
In a volatile capital market thats more unpredictable than usual, investors and operators are longing for a calm in the capital-market storm. In time, comfort in real estate investing will be restored. This relief may mean decreased values based on higher cap rates as a result of higher capital costs.
Theres no doubt that navigating through the current capital markets is choppy, given that the illiquidity in these markets has caused drastic changes in lending and investing criteria. Portfolio lenders, who have basically sat on the sidelines during the past few years of high leverage and aggressive pricing, are now capitalizing on the opportunity to bid on debt and equity opportunities. Due to current volatility and substantial losses on current portfolios, many lenders have been advised to hold off on quoting deals, except for existing clients or operators with a proven track record.
Its hard to say just how long the transition will last. During a turbulent market, investors and operators are wise to seek the guidance of an experienced advisor who can help steer toward smoother sailing. Hopefully better weather is just on the horizon.
Scott Sweeney is vice president and Joseph Maehler is a capital market specialist of Buchanan Storage Capital (BSC), a subsidiary of Buchanan Street Partners, which provides capital, advisory and investment sales services to self-storage owners nationwide. The company offers competitive capital through proprietary products along with structured finance and equity solutions through its advisory services. BSC has provided more than $3 billion of products and services to customers through its offices in Atlanta, Chicago, Los Angeles, Newport Beach, Calif., San Francisco and Washington, D.C. For more information, call 800.675.1902; visit www.buchananstoragecapital.com.