When it comes to sounding the alarm about rising interest rates, I’m starting to feel like “The Boy Who Cried Wolf.” It was only a few years into the recent economic recovery that we started warning self-storage owners about rising rates, only to experience modest increases. But as the fable goes, eventually the wolf comes to eat the sheep, and the little shepherd boy is left to fend for himself.
Fortunately, our story doesn’t have to come to such an abrupt and perilous ending. In fact, while rates are most definitely increasing, they’re still attractive, historically speaking. The 10-year swap and Treasury rates have hit 3 percent for the first time in more than four years and continue to float at that level. As of May, the 10-year Treasury rates were up 25 basis points from April and nearly 75 points from the same time last year.
What takeaways can we pull from this data, and what do rising interest rates mean for self-storage loans?
The Interest-Rate Equation
Remember that indexes such as the 10-year Treasury and swap are only half of the equation when calculating your interest rate. Looking at the following graph, it’s fair to say that loan spreads (the other half of the equation) generally move inversely to the index. While the spread shown is that of AAA commercial mortgage-backed securities (CMBS), there’s a strong correlation between how individual loans “price” and the pricing of CMBS bonds in the market. The last time the 10-year Treasury hit 3 percent, in 2014, AAA CMBS spreads were 20 to 25 basis points higher than today.
The Three-Legged Stool
When a borrower asks how a loan is sized, I often refer to a three-legged-stool analogy. The legs are loan-to-value (LTV), debt-service coverage ratio (DSCR) and debt yield. In recent years, values have recovered nicely, and while LTV is still an important consideration, it hasn’t been as much of a focal point. Debt yield has consistently been the factor that has constrained proceeds available for borrowers.
In the last few months, we’ve observed the beginning of a shift toward the DSCR metric. An asset’s DSCR is calculated as net cash flow divided by debt-service payments, which rise with interest rates. An increasing number of loans are being constrained by DSCR. In other words, holding the numerator (net cash flow) constant, an increase in the denominator (debt-service payments) equates to a lower DSCR.
Conventional wisdom dictates that capitalization (cap) rates tend to move directionally with interest rates. It makes sense that as the cost of capital rises, so must the yield expectation. Are increased interest rates met with a corresponding rise in cap rates? Not necessarily, but there are arguments for both viewpoints.
Several experts point to a healthy spread between cap rates and Treasury rates as providing a buffer from rising interest rates going forward. That’s not to say a dramatic rise in interest rates won’t eventually push cap rates higher, but there’s a cushion. For this reason, experts maintain that cap rates will largely remain flat or experience only modest increases this year.
While this may hold true in 2018, there’s an important takeaway: As the cost of debt goes up, would-be buyers’ expectations will begin to shift, possibly before sellers’ expectations do. Effectively, buyers and sellers may fall out of equilibrium as sellers resist the urge to reprice given higher debt costs. But in time, cap rates will have to shift upward to preserve any yield spread on these investment opportunities.
Given the points above, now probably isn’t the best time to overextend your project (and this is coming from a mortgage broker who makes more money if borrower uses more). Make no mistake, the lending environment is still healthy and loan volume has been strong, but consider where we are in the cycle. These are interesting times, and rising interest rates coupled with even slight increases in cap rates could result in an equity shortfall when a borrower next decides to refinance.
Interest rates may be on the rise after years of unprecedented lows, but the federal government’s recent action still falls in the realm of gradual increases. Instead of trying to perfectly time the best-case, low-interest-rate scenario, consider the “bird in the hand” approach. Compared to rates in the early 2000s and before, interest rates of 5 percent are still attractive.
The Federal Open Market Committee made good on its promise to increase the federal funds target rate three times in 2017. Thus far this year, it increased rates by a quarter point, and all signs point to at least another pair of quarter-point hikes. There’s a new federal reserve chairman, and he seems intent on following a similar protocol as his predecessor. Interest rates are on the rise and commercial real estate debt is more expensive than it was a year ago. Meanwhile, operating fundamentals remain strong and the debt markets are still quite healthy.
No one has a crystal ball, but given what I’ve outlined about today’s market conditions, the best advice I can offer is to consider your options and make a plan. That may inspire you to action or affirm your current debt product is a winner. Compare your existing interest rate with current commercial real estate rates and your expectations going forward. The interest rate on new debt may be higher, lower or in line with what you have in place.
However, consider this: If your loan is scheduled to mature in the next few years, it’s likely we’ll be in a higher interest-rate climate than today. Enlist the help of a financial advisor or mortgage banker to help you strategize around your goals and the loan products available to you.
Adam Karnes is the senior credit analyst for Chicago-based The BSC Group, where he specializes in the packaging of debt and equity financing requests for all commercial property types nationwide, with an emphasis on self-storage assets. He can be reached at 312.878.7561 or [email protected]. For more information, visit www.thebscgroup.com.