“Rollercoaster” is a good word to describe the beginning of this decade, though perhaps not quite strong enough. The onset of the COVID-19 pandemic in 2020 sent the economy into a tailspin, bringing unemployment to its highest level since the Great Depression. Hardships were far-reaching and are still impacting the country today. Even now there are numerous factors weighing on the economic landscape, including rising interest rates.
In this article, I’ll explore what increased rates mean for self-storage borrowers, both ones with existing debt as well as those seeking new financing. The bottom line is that while rates are rising, there’s still liquidity in the lending market.
How Did We Get Here?
To understand the current climate, let’s track the path that got us here. The Federal Funds Rate is the overnight borrowing interest rate between lending institutions, which heavily influences U.S. interest rates. In fact, you may recall that at the onset of the Great Recession in 2008, this rate dropped to a range of 0% to 0.25% following a peak above 5% in 2006.
It wasn’t until 2015 that the Federal Reserve increased rates again, pushing nine hikes between 2015 and 2018 during the ensuing recovery. Then a prospective trade war in 2019 resulted in three rate cuts. Enter COVID-19 in 2020, and the Fed cut the overnight rate back to zero to stimulate a struggling economy. Interest rates have been historically low for years, but since the end of 2019, borrowing costs have been excessively so.
The group of Central Bank presidents who make up the Federal Reserve Board, tasked with setting benchmark rates, have been busy in recent months. They’ve already pushed several hikes (with more to come) in an effort to curb rampant inflation. In general, interest-rate movement creates friction in lending markets, but the magnitude of these increases has been the main source of volatility. The 75-basis-point jump in June was the largest single increase in almost two decades, then the Fed pushed three more increases of the same size in July, September and November. As a result, borrowing costs have risen significantly.
The monetary policy action from the Fed has economists warning of a coming recession, while others believe we’re already in one. Even so, some experts believe a new recession won’t be as painful as those in the past, particularly 2008. The reason for the optimism is there are positive differences between now and then. Notably, banks have been more conservative to prevent over-leveraging. In 2008, it didn’t matter when the Fed cut rates because banks weren’t actively lending.
Impact on Borrowers
The contrast in attitude is stark. Lenders are making loans, albeit at higher interest rates. Plus, self-storage has achieved darling status in the lending community to the point where lenders price it as competitively as any other asset.
So, if interest rates have been increasing and may continue to do so, how do borrowers benefit? Well, as a starting point, remember that rates are still competitive historically speaking. As of November, permanent interest rates were 6% to 7% compared to the 3% to 4% range in 2021. Rates move regularly, and today’s high prices won’t last forever. This underscores the importance of making a plan that considers investment horizon and financing goals.
To provide a helpful framework around which to strategize debt options, let’s break borrower groups into two broad categories. The first comprises those who already own a self-storage facility and have existing debt. The second encompasses borrowers who are looking to acquire a property using debt.
Existing self-storage borrowers can be broken into subcategories of high- and low-leverage debt. For high-leverage borrowers, rising interest rates can be daunting, but there are strategies to navigate them. For example:
- If your high leverage is construction debt, the asset may appraise for quite a bit higher today. Thus, replacing the existing debt may bring the property into a lower leverage bracket against stabilized value.
- If the debt is held by a local bank, consider seeking a lender that’ll increase amortization to combat higher rates or extend a year of interest-only payments.
- Another option is fixed-rate debt to get out from under floating-rate debt. This takes the guesswork out of debt-service payments and allows borrowers to weather the storm until rates drop. If the new fixed rate isn’t lower than the current floating rate, it might be soon.
- If a high-leverage loan has a significant remaining term, the answer may be to do nothing. With no immediate need to refinance, the interest rate at hand may beat out what is available in the market.
- Finally, it shouldn’t be overlooked to have a discussion with your existing lender about extending the current loan.
Low-leverage borrowers have more options. For example, it may be possible to pull out equity for a new buying opportunity. Remember, interest rates are rising but still attractive historically; therefore, the incremental earnings on returned equity could be lucrative.
Stretching out the amortization, as noted above, may dampen changes in interest payments, even at a higher rate. Depending on the vintage of existing debt, a new interest rate could be comparable to the existing one, though that’s less likely with each passing day. There’s no shortage of banks that’ll consider a low-leverage self-storage deal. For example, consider a fixed seven- or 10-year term with a credit union, which are among the most competitive lenders in the industry today.
If there’s bridge debt in place on a self-storage facility, the key consideration is whether the property has stabilized to the point of qualifying for permanent (long-term, fixed-rate) debt. Once upon a time, floating-rate debt made all the sense in the world because it could offer a discount to fixed rates. However, as anyone with uncapped floating-rate debt can tell you, a run up of a few percentage points is painful. An asset in lease-up with floating bridge debt is one of the more challenging situations in the market today. Borrowers in this situation may want to consider hiring a mortgage broker or intermediary to help them navigate this scenario.
For those looking to acquire a self-storage facility, rising interest rates can throw a wrench into a great deal; but they may also present opportunities in 2023, as higher rates put downward pressure on prices. There’s an expression, “Marry the property, date the rate.” If you’re planning to hold an asset for the long term, it could make sense to buy through a credit union or local bank with flexible prepayment options and simply refinance when rates fall.
If the asset isn’t stabilized, it may require either floating-rate bridge debt or an adjustment to leverage expectations. Permanent lenders have debt-service coverage ratio minimums that help them size loans. As rates increase, hitting that threshold can create difficult conversations about scaling back proceeds.
Another thing to consider is that certain self-storage lenders will offer money with the option to earn more dollars out as cash flow improves. This may require more upfront equity, but it can be returned as additional dollars are earned. This might be the difference between having to use a floating-rate bridge product and tapping into fixed-rate debt. Regardless of how you use acquisition debt, it’s critical to stress-test the deal at higher rates to ensure there’s cushion.
Expect More Change
Interest rates are changing rapidly, so what’s true today may not be true tomorrow. Interest rates are on pace to continue increasing into the near future. While this has put pressure on certain transactions, it has by no means shut down the lending markets. Borrowing costs are up, but that doesn’t mean owners and investors will be cut off from financing. Lenders love self-storage and will bid those deals as competitively as possible for as long as it makes sense to do so.
Adam Karnes is a vice president of The BSC Group, a Chicago-based boutique mortgage banking firm. As a broker, he’s active in existing and new client relationship management and oversees transaction closings. Adam has experience with all commercial property types but specializes in the self-storage asset class, having underwritten more than $4 billion in loan requests since joining the firm. To reach him, call 312.878.7561; email [email protected].