The year 2008 will be remembered as a paradigm shift for valuing real estate. As the recession takes hold of the economy, we have seen lenders tightening their loan parameters, the pool of buyers reduced, and investors demanding a higher return on their equity.
Lenders
Today, typical loan-to-value ratios are 60 to 65 percent, as opposed to 80 to 90 percent achieved in the last two years. Debt-coverage ratios have increased from 1.1 to as much as 1.65. Whereas many loans were being signed between 5 percent and 6 percent, interest rates have increased to 7 percent or even higher.
In addition, many lenders have decreased the amount of their amortization periods. During the height of the credit boom, it was likely for borrowers to secure interest-only periods as well as 30-year amortization schedules. Now, it’s difficult to achieve interest-only periods and amortization schedules are trending toward 25 years.
One of the major shifts has been the validity and the liquidity of the sponsor, the person who is receiving the loan dollars. Two years ago, most loans were non-recourse, accomplished without personal liability of the sponsor. Today, the reverse is true: The sponsor is usually personally responsible for the loan, the recourse. In addition to recourse, a lender might require a substantial down payment from the sponsor and also require a deposit be made with the lender to meet reserve requirements.
Buyers
Many investors were able to enter the real estate market due to the low down-payment requirement and non-recourse loans. Factor in aggressive amortization and interest rates, and it’s easy to see the barriers to enter the real estate market were low; therefore, the demand for real estate skyrocketed. Since equity was plentiful, competition between buyers ensued. Many offerings had multiple letters of intent, leading buyers to curtail their return requirements to be the winning bidder.
As the lending environment changed in late 2007 and in 2008, many buyers had to sit on the sidelines because of the new levels of equity required to acquire real estate. As down payments of loans increased, buyers increased their equity position threefold.
Return Requirements
Over the last year, we have seen cap rates increase modestly for all real estate investments. Investors are focusing on in-place returns and capping net operating income (NOI) approximately 100 to 200 basis points higher than the preceding year.
One method investors used for the last 20 years is discounted cash flows (DCF), which is a projection of how a real estate property will perform over time and the return thereon. DCF includes not only today’s rents and expenses but also the growth of future rents, tax assessments, lease-up, and the value of the facility at the end of the hold period.
For office, retail and industrial, many investors create a 10-year DCF with a residual amount at the end of the term. A typical lease term for tenants is five to seven years. By having a 10-year DCF, an investor can incorporate tenant improvements and leasing commissions in their projections with the majority of the tenants expiring/renewing at least once.
With long-term leases, the typical real estate investment will be slow to capture the upside in value as the market recovers. Over the next couple of years, many leases will be signed at lower rental rates, locked for the next five to seven years.
Investors have usually put emphasis on the DCF with 50 percent of value derived from existing cash flow and the other half from the residual value. When the markets peaked in 2006-07, many investors lowered their cap rates and put more emphasis on the residual value. This was accomplished by initially low cap rates when purchasing the property, along with increasing rental rates and occupancy over the next 10 years for an aggressive residual value. The split dropped as low as 20 percent on cash flow to 80 percent residual—on a 10-year DCF. We are now seeing a shift back to a 50-50 split.
Self-Storage’s Uniqueness
While the self-storage industry shares many characteristics of typical real estate investments, a few things make it unique to investors. The main difference is the lease term. A typical self-storage lease is month to month. As the economy recovers, a self-storage investor will be able to capture the improving rental rates quicker by renewing month-to-month tenants at a higher rate.
In addition, a cap rate for office, industrial and retail is handled differently than self-storage. Annual tenant improvement, maintenance reserves and leasing commissions are excluded from NOI. Even if an investor is purchasing these types of assets at an 8 percent cap rate, it does not take into account the tenant improvement and commissions at lease expirations.
Self-storage does not have tenant improvements or leasing commissions, and maintenance reserves are included in NOI. Therefore, an investor purchasing a self-storage property at an 8 percent cap rate is a true return compared to office, industrial and retail cap rates.
Due to short leases in self-storage, most investors typically run a five-year DCF. The shorter hold period for self-storage will have an effect on the cash flow and residual split. Self-storage typically utilizes 35-65 percent on a stabilized property versus 50-50 for a 10-year DCF, which is attributed to the shorter hold time.
In 2008, self-storage operations were resilient against the recession. Many operators’ NOI increased or held steady for most of the year. Today there are higher barriers to entry and fewer lending dollars, which could mean less competition for those already in existence. Put it altogether and self-storage is poised to reap the benefits of a recovering economy.
Steve Mellon is a managing director at Holliday Fenoglio Fowler LP. He has been involved in excess of $1.3 billion worth of self-storage transactions. HFF’s self-storage professionals offer comprehensive services, specialized experience, knowledgeable investment sales and capital markets expertise to storage owners and investors nationwide. For more information, visit www.hffselfstorage.com.
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