Inside Self-Storage is part of the Informa Markets Division of Informa PLC

This site is operated by a business or businesses owned by Informa PLC and all copyright resides with them. Informa PLC's registered office is 5 Howick Place, London SW1P 1WG. Registered in England and Wales. Number 8860726.

Eyes Wide Open: Understanding the Self-Storage Lending Market With Interest Rates on the Rise

Understanding the Self-Storage Lending Market
Inflation has reached levels not seen in 40 years, and with interest rates on the rise, many borrowers may be hesitant to seek financing. Here’s an assessment of loan availability and what to expect from rates when financing a self-storage property under current market conditions.

The sharp increase in interest rates since the beginning of the year has caught many people by surprise. During the heart of the coronavirus pandemic, policymakers made a concerted effort to maintain low interest rates to fuel a recovery from its economic effects. Fast forward to today, and it’s a different picture. With unemployment near record lows, labor shortages, ongoing supply-chain issues, huge fuel-price increases, and strong consumer demand for goods and services, we’re now in the throes of inflationary times unseen in more than 40 years.

The rise of interest rates has been fueled by the actions of the 12-member Federal Open Market Committee (FOMC), which controls the federal funds rate. This is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes to this rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates and the available amount of money and credit. Ultimately, this all influences a range of economic variables including employment, output, and the prices of goods and services.

Let’s examine how all this relates to the availability of loans for self-storage properties and what borrowers can expect from rates when seeking financing.

Availability of Financing

Unlike other market cycles, such as the 2008 recession when capital was difficult to find at any cost, financing is readily available from all types of funding sources for all types of loan requests. Whether you’re seeking money for a development, acquisition or expansion, or perhaps looking to refinance, there are lenders ready to provide options for you.

Self-storage has been a benefactor of consumer behavior during the pandemic. This is supported by the quarterly announcements by the industry’s real estate investment trusts, which have all reported healthy occupancies near the mid-90s as well as year-over-year revenue increases of more than 15%. This type of performance once again shows the resiliency of self-storage through challenging cycles. Coming out of the pandemic, it is seen by many lending sources as a preferred property type, along with the industrial and multi-family sectors.

Rising Fed Fund Rates

Variable-rate loans are typically tied to indices that move almost in sync with the movement of the fed fund rate. For example, see the following table:

Interest-Rates-Table.JPG

If the FOMC continues to bump up the fed funds rate, a borrower who has a variable-rate loan is likely to see their interest rate increase in steps similar to the Fed’s increases. There is a probability of more than 70% that the fed funds rate will reach 2.25% by the end of the year, according to the Chicago Merchandise Exchange FedWatch Tool.

As it stands now, there may be many instances in which variable-rate loans have interest rates lower than comparative fixed-rate loans. However, those scenarios may reverse if the FOMC executes its plan to continue to increase the fed funds rate. As a reference, most construction loans are variable-rate (and interest-only) through construction as well as 12 to 36 months during lease-up. If you have or anticipate having a variable-rate loan, it’s prudent to budget for increases in interest expense over the remaining term. For construction financing, be sure to create an adequate interest reserve into the loan.

The interest for fixed-rate mortgages has also risen since the beginning of the year. In general, a loan that would have likely had a fixed interest rate quoted at 3.25% to 3.50% six months ago would probably be quoted in the 4.5% to 5.5% range today. Many fixed-rate loans are priced on a spread over the relative term Treasury or SOFR rate indices.

It’s important to note that every loan transaction has unique characteristics and is priced accordingly. There’s also myriad other terms to consider when choosing an option that best aligns with your investment objectives. The Treasury yield doesn’t necessarily move in sync with the FOMC actions. In fact, in May, the 10-year Treasury yield dropped more than .25%. In addition, at the end of May, the yield curve was flat, with 5- and 10-year Treasury yields being almost identical.

Loan Size Relative to Value

Since self-storage is in high demand as a commercial property type, ranging from traditional facilities in rural communities to institutional, multi-story, class-A properties on prime real estate in urban-infill locations, valuations and sales remain extremely aggressive. The more forceful a property is purchased relative to existing cash flow (i.e., the lower the capitalization rate), the harder it is to receive maximum proceeds based on maximum loan-to-value (LTV) parameters.

Loans for acquisitions and refinancing are primarily underwritten and sized based on historical operating results, with a minimum debt-service coverage (DSC). This is calculated by dividing the net operating income (NOI) by the debt payment. Minimum DSC usually ranges from 1.2 to 1.35. With rising rates and historically low valuations, these constraints may limit loan size to an amount significantly less than the maximum LTV.

To give some perspective, a term sheet may have a maximum LTV of 75% and a minimum DSC of 1.3. The resulting loan could potentially size out to 55% to 60% LTV, well short of the maximum 75% LTV based on the interest rate, amortization and capitalization rate used on valuation.

Reduced Prepayment Penalties

If you have self-storage facilities financed through commercial mortgage-backed securities (CMBS) or have a loan with a corresponding swap instrument, increased interest rates work in your favor. CMBS loans, which always have either defeasance or yield-maintenance prepayment clauses, are prohibitive when the current interest rates are significantly lower than the note interest rate. As rates rise, those prepayment penalties are reduced meaningfully.

I recently updated a prepayment-penalty calculation that was more than $900,000 before the increase in rates. Today, it’s closer to $350,000. While that’s still significant, it’s now in a range in which it’s practical to prepay the existing debt and pull significant equity by refinancing the property. In cases that have a swap instrument in place (to make a variable-rate loan fixed through a counter-party agreement), many owners may be able to pay off existing loans at a premium, meaning they’ll owe less than their current outstanding balance.

Financing Still Makes Good Sense

Another reason to consider financing now is to take advantage of strong operating results. Many self-storage owners have logged year-over-year NOI increases of 10% to 20%. If that’s you, you’re in an enviable position to consider refinancing and access a significant return of equity on your investments.

The low interest rates obtained over the past two years were an aberration and not sustainable. The current rates are well within the customary norm. To determine quotes on new loans, lenders continually have to manage their respective lending platforms with consideration to specific availability and cost of funds and asset allocation. What’s happening in the current market is larger than usual differentiation between lenders in comparative loan terms, amounts and rates.

Relationships with current lenders have value, business purpose and advantages. When it’s time to shop the market, it’s beneficial to bring in an expert loan broker who can provide guidance and insight. Just because rates are on the rise doesn’t necessarily mean that self-storage financing should be off the table. You just have to plan accordingly.

Neal Gussis is a principal at mortgage-banking firm CCM Commercial Mortgage. With more than 30 years of experience as a national self-storage mortgage broker and advisor, he specializes in securing debt and equity for self-storage owners nationwide. He can be reached at 847.922.3750 or [email protected].

Hide comments
account-default-image

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish