We all know the business adage about how a level playing field allows for fair competition. Given 2007’s financial turmoil, the turf for self-storage real estate financing and property transactions is still level, but at a dramatically different point of balance than what many owners became accustomed to in recent years.
With this new game, we’re all confronted with the same difficult market conditions, so it’s not a question of whether anyone has an unfair advantage, but rather how each of us copes with the current environment. Thriving on this redefined field will require property owners to readjust their points of equilibrium and gain their balance as market shifts continue to redefine how we conduct real estate-related transactions.
New Rules of Engagement
Last year’s credit-market turmoil has led to new, much more conservative rules of engagement for storage owners. Become familiar with these redefined rules, because they’ll ultimately affect how you operate your business and plan future investment strategies.
Wall Street has redefined the “best practices” of underwriting commercial real estate by reverting to more conservative historical norms. Gone are the recent halcyon days of lending on projected cash flows, interest-only underwriting, high-leverage first-mortgage debt, and lax debt-service-coverage (DSC) standards. Going forward, the more conservative measurements of in-place rents and historical cash flow will reign supreme. Investors will also need higher levels of old-fashioned equity and bottom-line cash flow, as lenders will strictly adhere to 75 percent to 80 percent loan-to-value (LTV) standards and 1.2x DSC constraints.
The risk profile on debt capital has also changed, resulting in wider credit spreads by at least 100 basis points on average. Further, there’ll be a clear differentiation between short-term bridge loans and long-term permanent debt, as lenders will segregate these products using leverage, pricing and deal structure.
For self-storage owners, the overall math is pretty straightforward: More equity and more expensive debt equal a higher overall weighted cost of capital.
Tighter underwriting standards and more expensive capital will flow through the real estate markets and clearly affect deal dynamics and investor profiles through cap rates and internal rates of return (IRRs). A cap rate is the ratio of an asset’s cash flow to its value; it’s a proxy used by investors to quickly compare yields on different assets. IRR is an alternative method that measures the true annual earnings on an investment over time by accounting for the time value of money. While cap rates and IRRs are not directly correlated, investors deploy both analytical measures when considering whether to purchase, sell or finance self-storage properties.
On our new playing field, the rules of engagement offer the harsh reality that lenders no longer give credit for projected cash-flow improvements and higher values at reversion. This forces investors to derive values based on cash flow in place and to bridge any debt gaps with more precious equity. Given this new rule, it seems reasonable that cap rates will widen by an amount sufficient to generate the IRRs investors require, as lower LTV ratios and the end of cap-rate compression will make it harder for projected IRRs to be met.
It’s widely expected that cap rates will widen by at least 30, and perhaps as much as 100 basis points, depending on the asset’s quality, location and performance. Cap-rate increases will conversely contribute to a decline in commercial property values.
What seems to be lost in all of the translation is investors have forgotten about the continual increase in value of their storage assets during the last five to 10 years when stabilized cap rates were lucky to be below double digits. While the market turmoil has not reached the double-digit level, it’s important to note that the pricing offered on deals today should still be historically attractive to investors who have owned their assets for more than five years.
Winners and Losers on the Field
Now that we’ve identified some of the playing-field changes and the new rules of engagement, let’s consider how they’ll impact market participants.
On the lending side, the benefactors will be life companies and commercial banks. Any financial institution with a healthy balance sheet and traditional “portfolio” lending platform that is not reliant on the capital markets to execute a loan sale is in a position to take immediate advantage in today’s marketplace. This is not to say that conduits will stop lending to self-storage owners; but market uncertainty and execution risk of their lending platforms certainly put conduit products at a disadvantage compared to life companies and banks. Accordingly, conduit volume is expected to drop significantly in the near term.
On the investment side, highly leveraged investors with short-term debt positions maturing in the near term are also at a disadvantage. These investors may find their equity has evaporated and lenders are unwilling to refinance or extend their loans.
Investors hoping to capitalize on aggressive market conditions by fully leveraging transitional or lease-up assets to refinance and cash out in the short term may also find themselves in trouble, especially if these properties have not performed as expected. Borrowers will likely find that loan servicers?particularly those acting under obligation from a commercial mortgage-backed security execution?will not be willing to work out loans, and may choose instead to foreclose on a property to minimize losses for the trust.
On the flip side, these new market conditions could present strategic buying opportunities for well-positioned investors with strong equity positions and healthy balance sheets. Investors who have seasoned loans with large equity positions available for refinance may consider cashing out some of their equity to build cash reserves and be in position to capitalize on market opportunities.
Accordingly, investors with assets that are well-placed and who enjoy strong local or regional market share due to owning a portfolio within a specific market may still be able to achieve pricing near 2007’s peak levels. While the pool of buyers has certainly decreased, investors’ acquisition appetites for this type of portfolio product remain strong. We expect buyers using low leverage and all cash will become active in 2008.
Even though the playing field has become more challenging, there are still numerous options available for self-storage owners looking to finance, acquire or sell. The key is recognizing the new rules of engagement and keeping your balance. Proper technique will win higher scores in today’s game.
Shawn Hill is a principal at Chicago-based The BSC Group, where he provides mortgage brokerage and financial consulting solutions to self-storage and other commercial real estate owners. He is a former senior vice president with Beacon Realty Capital. To reach him, call 773.517.8504; e-mail [email protected].
Minh Tran is the managing director of brokerage/east at Storage Investment Advisors and can be reached at 713.376.3107 or [email protected].