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Self-Storage Money Matters: Financing, Credit and Property Value

May 7, 2008

7 Min Read
Self-Storage Money Matters: Financing, Credit and Property Value

It’s time to sit up and take notice. The times have changed, and nobody seems to be setting up shop on Easy Street anymore.

It is abundantly clear that the so-called sub-prime mortgage debacle may be just the tip of the iceberg of problems in modern finance markets. Easy to obtain, cheap credit is the great lubricant that makes the engines of commerce really hum. Unfortunately these lubricating characteristics are the part of the formula that ultimately causes the credit system to break down.

Credit availability is largely a function of the lender’s confidence to be paid back with reasonable interest. Unfortunately, there are fewer institutions, or individuals, that find they have enough confidence in borrowers to lend money without what would have been significantly excessive guarantees or collateral just six months ago. One reason short-term Treasury Notes are yielding so little interest is that many investors are buying them just to preserve value because they can’t be sure that many of the traditional money funds, and the other so-called secure short-term investments, are not turning out to be secure and illiquid.

What About Wall Street?

We all remember Jimmy Stewart in It’s a Wonderful Life, the run on his little bank and what a pickle it put him in. Well, it is the same story today except that the bank is now the whole international financial system, and it appears to be in trouble because of lending unlikely to be paid back or having the collateral to cover the debt. Thank you, Wall Street, for inventing these "innovative" ways to create credit that appear to be safe, but manage to fail to be repaid just after Wall Street sells it.

You might ask how could we, as mere mortals, have known what was going on? There is an easy-to-read little book called, A Short History of Financial Euphoria, written in 1996 by John Kenneth Galbraith, the famous and witty economist. The book not only tells of similar events in history, but more important, tells how to identify the next wave of "euphoria."

Moving Targets

Being in the self-storage business puts you square in the middle of the real estate business and, thus, the value of your property and the financing are ruled by the valuations imposed by the real estate world. For the last four or five years this arrangement has been absolutely terrific for self-storage owners as cap rates declined between 2.5 percent to 3.5 percent. (Remember, as cap rates decline, values go up; hence, the equation Income/Cap Rates = Value).

At the low end of the range, this means facility value went up by about 37 percent during that time without any increase in income. If you kept your old loan (assuming 75 percent leverage), your equity shot up by 127 percent. But the story still gets better. At the same time cap rates were dropping, interest rates on loans declined by about 3 percent, and the amount you could borrow went from 75 percent of value to 80 percent, possibly more if you included the benefits of substantially looser underwriting.

The combination of the value increase, lower interest rates and easier underwriting would mean you could add about 50 percent to the loan amount and pay roughly the same amount of interest as before the refinance. All of this was available without any personal liability. The real estate business was very good to self-storage owners over the last handful of years. It just doesn’t get any better than free money!

So It Goes

Starting last summer, things began to change. The sub-prime market in residential real estate got very weak, the commercial loan folks said the loan-to-value ratios were out of whack and wanted the underwriting tightened up, then the big Wall Street Banks started taking big write-downs. To quote Kurt Vonnegut, "and so it goes."

Today we find ourselves in quite a different spot than a year ago. Cap rates have gone up between 1 percent and 1.5 percent, causing values to decrease, but even worse, there are fewer buyers around. Despite the Fed lowering short-term rates, the spreads (the difference between the 10-year U.S. Treasury rate and the interest rate) lenders charge for risk have almost tripled, leaving loan rates just slightly above where they were last year (which are still very reasonable in the context of a longer history). The bad news is that all of the Wall Street generated conduit loans are gone; thus, the life companies and banks can now get the exact terms they want and need from needy borrowers.

The underwriting is much more restrictive (maybe saner):

  • 12-months trailing income

  • No proforma income

  • 60 percent to 70 percent loan-to-value ratio

  • Good markets only

The remaining lenders, while not impossible, can be pretty picky. I asked Steve Clifford at NorthMarq to compare the loan a hypothetical class-A quality facility could have gotten last February and again this February. His summary is below.

The bad news is that not only are loans harder for you to get, but they are also harder for your potential buyer to get. Even though the cap rates have gone up and values down, the lower loan-to-value ratios means the buyer must still put up about as much equity. This doesn’t mean there are no buyers; there are still many, but they aren’t quite as eager as before.

Evaluation Time

This is the section where, with the advice and opinions presented here and $3.75, you can get a latté at Starbucks. So, for what it is worth, I will try answering the looming questions:

  • How bad is it? I don’t think anyone knows, but the bad numbers keep getting bigger and coming from unexpected places. I’ve been in the real estate business 37 years and have seen three major downturns, and this is by far the most widespread problem yet. One measure of the problem so far might be what has happened to the self-storage REITs. For example, one year ago the stock of PSA was trading at $113 per share; today it’s $73. This is a stock with improved business fundamentals!

  • When will it be over? No one knows, but no one seriously thinks it will be over quickly. Other commercial real estate performance is probably going to get worse and housing prices may still go down more.

  • What do we do? If you don’t have a loan with a fixed interest rate and at least five or six years left on the term, refinance! Now!Get more term. Don’t wait! If you are thinking about selling in the next three years and maybe even five years, sell now! Cap rates will go up more (values down), if for no other reason than longer-term interest rates will go up as investors demand more return for their risk. Think about the value numbers in the first paragraph, but in reverse.

Make sure your property is competitive in your marketplace by comparing your facility to your competitors. Compare visibility, location, access, maintenance, employee quality, security, traffic counts and, of course, price.

Check at the city offices for new building permits or plan approvals in your market. Give very serious thoughts to the potential of overbuilding. If a new facility causes your occupancy to go down by just 5 percent and your rents to go down by 5 percent (including rent concessions), your equity (assuming a 75 percent loan) will decline between 50 percent and 60 percent.

So there you have it. Yes, there’s a new sheriff in town. He doesn’t appear to smile much and he packs a powerful punch. My advice to you is to stand tall and walk on the straight and narrow side ... at least for the time being.

Michael L. McCune is president of the Argus Self Storage Sales Network, a self-storage real estate brokerage and development company based in Denver. Argus also operates www.selfstorage.com, a marketing medium for owners in the self-storage industry. For more information, call 800.55.STORE.

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