While the 2008 financial meltdown created stormy conditions for commercial real estate owners and lenders nationwide, the climate in the self-storage industry has been relatively mild, with a nice wind at our backs. With high occupancy rates and increasing rents alongside numerous attractive financing options, facility operators have seen their investments appreciate in recent years. Many have exploited low capitalization (cap) rates and sold their properties for great returns, while others have expanded and developed new sites. Many have also refinanced their loans to lower rates and recapture some equity.
Except for new-development financing, there have been few post-recession headwinds when seeking appealing loan alternatives, but don’t expect this calm weather pattern to last indefinitely. There are clear indications that atmospheric conditions are changing within the industry and the capital markets. This will affect your financing and refinancing options. Here’s how.
A void occurred in self-storage supply when virtually no new properties were constructed during the height of the recession (2008 to 2011). During the last five years, however, high purchase prices for existing properties and solid anticipated returns for development projects have contributed to the industry’s expansion, with new facilities appearing steadily since 2013.
A governing factor for new construction has been a conservative lending community, which continues to use its discretion when financing developments. Because underwriting standards closely scrutinize any project sponsorship’s financial strength and experience, most of the new supply coming online is being built by existing operators.
The storage industry has enjoyed an expansionary cycle, which many believe will start leveling off in 2018 or 2019. The self-storage real estate investment trusts (REITs) have all reported that year-over-year revenue increases are now receding in many key metropolitan areas. A few markets are even down year over year. Notably, the REITs have also reported offering more concessions and discounts to lure new customers. On a brighter note, they’re all still reporting near-peak occupancy levels.
Construction financing is again becoming more difficult to obtain. There are two primary reasons for this: First, lenders need to maintain balance in their financing portfolios, and in many cases, the construction “bucket” is now full. Second, with this being the fifth year of the current expansion cycle, they’re more closely examining new and prospective competition when offering terms for development loans or refinancing.
Historically, the Federal Reserve has used the Federal Funds Rate to stimulate, maintain or slow economic growth. Fed comments and actions have heightened expectations that there will be three rate hikes in 2017, with two 0.25 percent hikes already occurring in March and June. In mid-August, the Fed’s target fund rate was 1.25 percent, with indications it would increase to 1.50 percent when the next rate hike is implemented by year-end.
The Prime rate and LIBOR indices move in sync with the Federal Funds Rate. In August, Prime was 4.25 percent, and the 30-day LIBOR was at 1.23 percent. Both are expected to rise 0.25 percent by year-end as well.
While there are many factors to consider given the capital markets’ dynamic nature, the knee-jerk reaction to the Fed’s decision to raise rates will be higher costs of funds and steeper borrowing rates.
Variable vs. Fixed Rates
To hedge against these rate increases, many storage owners have locked into fixed-rate financing during the past decade, since mortgage rates have hovered at historically low levels. Simultaneously, others have capitalized on favorable variable-rate terms that have been even lower than many fixed-rate options.
Maintaining an adjustable-rate mortgage is a risk tolerance and timing equation. As long as variable rates stay low, you come out ahead. Conversely, if rates begin to rise, it may cost you more in the long run. There are some indications that the benchmark Fed Funds Rate could reach close to 3 percent at some point in 2018 or 2019, which means variable-rate mortgages will likely be in the range of 5 percent to 6 percent within the next two years.
If you have variable-rate financing, seriously consider moving to a fixed-rate loan now, especially since many variable-rate loans offer this as an option. Further, many lenders have vehicles that allow you to fix an adjustable loan by entering a swap agreement.
The indices and spreads associated with five- to 10-year fixed-rate loans depend on many factors beyond the benchmark rate and, therefore, don’t move in the same manner. Since the beginning of 2017, the Treasury yield has remained relatively flat, along with the corresponding spreads lenders quote above the indices.
Despite typical market cyclicality and three recessions since 1985, there’s been a noticeable pattern of long-term Treasury yields declining and moving in a distinctly different manner than the short-term Fed Funds benchmark rate. The primary factors influencing Treasury yields include bond supply, investor demand, economic conditions, monetary policy and inflation. With so many variables, Treasury yields aren’t an easy equation to understand or predict.
The U.S. economy is currently supported by the lowest unemployment rate since 2007, and the stock market is reaching new heights, with the Dow Jones average eclipsing the 22,000 mark for the first time. While strong economic results often usher in inflation, national and global inflation rates have remained low. While everyone can make conclusions on whether Treasury yields will rise or continue to stay relatively flat, there’s no question that it’s a good time to consider fixing a mortgage rate given the strong certainty that variable-rate loans will climb.
Headwinds Facing New Development
No matter which way they turn, developers are getting a face full of financing headwinds. In addition to increased lender scrutiny and a limited supply of construction loans, rising short-term rates will certainly increase a developer’s cost of funds. Consider, as well, that developers are seeing higher construction costs and, in many cases, long lead times for permitting and building approvals.
Nearly all construction loans are variable-rate products. On top of potentially higher material and labor costs, developers should anticipate an interest rate increase of 0.5 percent to 1.5 percent on their construction loans. Lastly, they should be certain their pro forma has conservative lease-up projections that consider the future supply of storage units in their local marketplace.
Make Your Own Forecast
While the self-storage industry has proven its resiliency time and time again through stormy development and capital-market cycles, we should expect varying degrees of headwinds during the next couple of years. As we all know, great weather never lasts.
Prepare for these changing conditions by forecasting your own upcoming needs, while keeping your operation competitive. You can do this by considering potential new competitors and staying informed about available financing terms. For some, it may be time to refinance an existing loan, especially if you have variable-rate financing. More than ever, developers should closely scrutinize new projects to determine if their projections require updating and if the expected returns still meet their investment criteria.
Neal Gussis is a principal at CCM Commercial Mortgage, a mortgage-banking firm that secures financing for self-storage owners nationwide. With more than 25 years of experience as a national self-storage mortgage broker and adviser, Neal has secured more than $3 billion of self-storage transactions for operators. For more information, call 224.938.9419; e-mail [email protected]; visit www.ccmcommercialmortgage.com.