Self-Storage Financing Strategies to Hedge Against the Next Recession

The U.S. economy is enjoying one of its most profound, expansionary periods in history. Interest rates are hovering near historic lows and the unemployment rate is the lowest it’s been in 50 years. Still, it would be an oversight to get overly comfortable with these ideal conditions. All this success should make self-storage investors ask: How long can these historically low rates last, and how can I protect myself?

The Markers

Historically, there tends to be an economic recession approximately every 10 years, and several key indicators suggest the next one may be well within sight. The first marker to consider is related to the unemployment rate. Counterintuitively, low unemployment is often a sign of a coming recession. As of this writing, unemployment is around 3.6 percent, the lowest it’s been since December 1969.

Another favored indicator is the inflation rate. For years, the Federal Reserve has signaled that inflation and unemployment are in a range where it would consider raising interest rates. Despite that, the personal consumption expenditures (PCE) price index—the central bank's preferred inflation gauge—is up just 1.5 percent on an annualized basis.

The most telling indicator, however, might be the current yield curve on U.S. Treasury securities. Historically, an inverted yield curve has been a leading indicator of a coming recession because it signifies higher interest rates on shorter-term vs. longer-term bonds. It has predicted the past seven recessions, with each one coming, on average, about 10 years apart. It’s been just over 10 years since the Great Recession ended in 2009.

With a seemingly inevitable slump bound to take place soon, now’s the time for self-storage investors to act. The challenge for borrowers is how to protect their real estate investments and financial well-being with a recession looming. Logically, debt is an area in which investors may find themselves vulnerable when economic conditions become unsettled. For this reason, it’s critical to be well-versed in the various debt products available, to understand the potential positive and negative implications.

Bank Debt

The most common form of financing for self-storage owners is traditional bank debt. Bank loans are typically three- to five-year recourse with covenants attached to address defaults on the borrower’s end. As a reminder, loan covenants are conditions that obligate a borrower to fulfill or maintain certain requirements or, conversely, forbid him from undertaking certain actions. There are consequences if these conditions are fulfilled or not, depending on the situation.

Although common, bank loans can be problematic in times of economic uncertainty. One of the most obvious difficulties that can arise is the length of term. Historically, recessions last two to three years. Unless the timing is near perfect, borrowers with a three- to five-year loan are at risk of it maturing in the middle of, or immediately following, the slump. Keep in mind these are also recourse loans, which means borrowers aren’t only at risk of losing their property, they may be personally liable for damages (losses) sustained by the bank in the event of default.

In a recessionary environment, a borrower may find himself in a tough spot if an “itchy” lender is worried about its loan portfolio. Banks are heavily regulated and monitored. They follow guidelines and have a fiduciary requirement to act responsibly. Therefore, a bank lender may work to rebalance a loan or accelerate it to maturity if it perceives warning signs from the economy or even a borrower’s ability to make scheduled payments. It’s able to do this through the covenants included in the loan documents.

CMBS Debt

The good news is there are many other options available to finance self-storage. One is through the commercial mortgage-backed securities (CMBS) market. CMBS loans are typically 10-year, nonrecourse loans with fixed interest rates. More importantly, due to the broader nature of the construct of these deals, the lender’s ability to default or accelerate a loan is restricted and much more favorable for borrowers.

To be clear, this isn’t a legal article, and I’m not providing legal guidance here. Consider this more of a practical argument. All loan agreements include fine print and built-in remedies to protect the lender if the borrower doesn’t perform. That said, as long as a CMBS borrower continues to make payments, he can continue to operate business as usual. If the cash flow deteriorates beyond a certain level, the lender may have the right to start trapping the property’s cash flow through a “cash management” covenant; but even in this scenario, the borrower technically wouldn’t be in default or in jeopardy of the lender attempting to require a paydown.

In fact, prepayment in CMBS is problematic. Therefore, the borrower would most likely have to stop making payments entirely to default the loan. If that were to occur, the loan would enter a negotiated workout with the loan servicer.

Like banks, CMBS lenders have many rights included in their loan documents. Again, we’re simplifying something nuanced to make a point, but the bottom line is these loans can be structured with borrower-favorable protective elements that can be compelling in a recession scenario.

Although it’s a simple concept, borrowers should also consider the basic element of time as it relates to the loan-maturity schedule when considering their finance options. More specifically, by extending the fixed-rate loan term from five to 10 years, the borrower is far less likely to experience a loan maturity in the middle of a recession. With a historical pattern to fall back on, combined with some strategic planning, he may be able to time his refinance activity to bridge over what has been a somewhat consistent recession pattern simply by using longer-term, fixed-rate loans.

One final benefit of CMBS compared to bank debt is recourse, or borrower liability. CMBS loans are nonrecourse, which means the property itself—not the borrower’s personal financial empire—is the collateral. This is notably different from bank loans, which typically require a recourse guaranty, whereby the lender has access to both the property and the borrower’s personal finances to remedy a loss. So long as none of the recourse carveouts have been violated, a CMBS loan significantly limits the borrower’s personal risk exposure. In the doomsday scenario, a CMBS borrower can give the lender the keys to the property and walk away without fear that the lender will seek additional compensation or future judgment.

Planning for the Future

While even the most studied economist can’t tell us when the next recession will start, it’s safe to say one will hit soon. Rather than fret about what’s out of your control, create an action plan. It’s in every borrower’s best interest to have a roadmap for the future to ensure financial protection of a commercial real estate portfolio.

Long-term, fixed-rate debt is a great way to weather a recession. Borrowers can currently lock into 10-year, nonrecourse, fixed-rate debt in the low to mid 4 percent range. This includes significant interest-only periods that can greatly enhance cash flow, if desired. Not only does this strategy allow investors to lock the interest rate at historical lows, it provides 10 stress-free years before your next loan maturity. No investor wants to be forced to transact or refinance during a recession, especially with an itchy lender that’s forcing the conversation through technical default criteria.

By taking advantage of long-term debt options at today’s exceptional interest rates, self-storage borrowers should be able to minimize the stress that often comes with a recession. With no certainty as to when the next decline will hit, there’s no better time than now to start looking at safer approaches to financing.

Shawn Hill is a principal at Chicago-based The BSC Group LLC, where he advises clients nationwide on debt and equity financing as well as loan-workout services for all commercial property types, with an emphasis on the self-storage asset class. To reach him, call 312.207.8237; e-mail [email protected]; visit www.thebscgroup.com.