The Self-Storage Financial Climate: Strategies to Keep Cool if Rates Heat Up

Interest rates can be a lot like the weather: difficult to accurately predict. I’ve lived in Chicago my entire life, and if someone had tried to bet me that I would be wearing shorts and golfing in mid-February, I would’ve taken a large wager and chalked up the opponent’s delusional optimism to a case of the Winter Blues.

Thankfully, I didn’t make such a bet. If I had, I would’ve lost big. Surprisingly, for almost a week in February, the temperature in the Windy City hovered around 65 degrees, topping out above 70 one day. I certainly didn’t see it coming, and it’s now abundantly clear that I have no business forecasting the weather.

Given my profession as a mortgage banker, I’m probably better suited to predicting interest rates for the self-storage industry. But I learned long ago there’s no upside in trying to forecast such a thing. Even the most seasoned economists can’t accurately estimate the speed and magnitude at which rates will change. There are simply too many complicating factors that can and will affect the outcome.

After many years of smooth sailing on the seas of self-storage finance, with historically low rates and little volatility, real estate investors are now left wondering what the future holds and how pending changes might impact their portfolios. Between the presidential-election outcome and indicators from the Federal Reserve, they know low rates likely can’t last. What might that mean for self-storage borrowers in the year ahead?

Headwinds Predicted

In 2015, the Federal Reserve began to signal that incremental increases were on the horizon. Yet between 2015 and 2016, there were only two modest 0.25 percent rate increases, both at the end of each year. This year, the federal funds rate is likely to continue rising, but it’s important to remember that the benchmark index is only one component of a borrower’s cost of funds; the other component is the risk premium spread.

Much like with broader weather patterns, to gain proper perspective, it’s often useful to revisit the past as a point of reference. Notably in 2007, the average all-in mortgage rate for self-storage assets originated via commercial mortgage-backed securities (CMBS) loans was roughly 6 percent. At the time, the corresponding federal funds rate ranged from 4.25 to 4.75 percent, and the 10-Year Treasury ranged from a low of 3.88 percent to a high of 5.12 percent over the course of that year. Comparatively, a sample of CMBS loans originated in 2016 had an average coupon of 4.8 percent, with the fed funds rate at or around 0.25 percent, and a corresponding range of 1.37 percent to 2.59 percent for the 10-Year Treasury.

This clearly illustrates the inverse relationship between the forces that affect risk premium spread and the underlying indices that have generally existed through time. The good news for borrowers is CMBS spreads clearly have room to come in as the Fed considers rate increases, and the benchmark indices for CMBS (treasuries and swaps) respond accordingly.

Be Prepared for Changing Conditions

The bottom line is nobody can accurately predict when the Fed will increase rates or where things will shake out, but the general sentiment is rates are rising. With that in mind, a constructive approach is to formulate a strategic game plan to take advantage of what should still be a great year of historically low rates, relatively speaking. Below are some points to consider as you think about the year ahead.

• Rates are still historically low. Interest rates may be on the rise after years of unprecedented lows, but the Fed has been forthright in telegraphing its plan to gradually increase rates. Instead of trying to perfectly time the best-case, low-interest-rate scenario, consider the “bird in the hand” approach. Rates are low, and an opportunity may still exist to lock in a long-term, fixed-rate debt product at an attractive rate.
• It’s still a healthy lending environment, one favorable for borrowers. The capital markets are firing on all cylinders, and there are many options. This is a stark contrast to the lending landscape in the immediate aftermath of the Great Recession. Lending options include banks, credit unions, CMBS, life companies, private capital and the Small Business Administration.
• There are strong commercial real estate fundamentals. These have continued to recover over the last few years, and the outlook remains solid. Self-storage rent and occupancies are robust as highlighted by the public real estate investment trusts, and capitalization rates are historically low, so borrowing capacity has seldom been higher. In addition, self-storage made a strong showing as a recession-resistant asset class during the last downturn, evidenced by a relatively inelastic demand profile.
• There could be regulatory regression. President Trump recently signed an executive order to integrate regulatory-reform officers into certain federal agencies. While it’s too early to say whether these task forces will be effective, it’s worth considering that the goal of these groups will be to curb excessive regulation. Remember that uncertainty surrounding the implementation of the latest Dodd Frank Wall Street Act requirements was a major contributing factor to a choppy, if not lackluster year of issuance in the CMBS market.
• Inflation isn’t all bad. Property owners generally benefit from an ability to push rents during times of inflation, which results in higher net operating income. Self-storage owners can benefit from the short-term nature of their leases, which means they can theoretically push asking rents to offset the increased cost of borrowing and operating expenses if inflationary pressures take hold.
• There will be gradual increases, not spikes. Although the Fed has finally made good on its promise to begin raising interest rates, it thankfully hasn’t been forthright in telegraphing its plan. The policy thus far has been to foreshadow these increases, giving the market time to absorb them. If the economy continues on a path similar to 2016, it should mean the Fed will gradually raise rates in 2017 as well.
• Watch the floating-rate debt. Borrowers with existing floating-rate loans are more susceptible in a rising rate environment. For a borrower who’s been using floating-rate debt to take advantage of the low rates, now might be the time to consider adjusting that strategy and locking into a longer-term, fixed-rate product.
• Be mindful on construction loans. For borrowers who plan to build and borrow floating-rate construction debt, be sure to “stress” the interest rate over the term of the loan. Similar to the vulnerability of traditional floating-rate debt holders to rising interest rates, floating-rate construction debt is also at risk. Would-be developers may sleep more soundly knowing they’ve over-estimated the breakeven interest carry and operating soft costs during the term than the alternative, which likely means a capital call to you or your investors.

Know When to Seek Shelter

The outlook remains favorable, but it’s extremely important for borrowers and investors to stay informed of changing conditions. Interest rates may officially be on the rise; however, this has been in the long-term forecast for some time and should hardly come as a surprise.

The silver lining is the economy is on solid footing, values remain high, rents and occupancies are strong, and capital is plentiful. The truth is that much like the weather, we don’t know exactly what tomorrow holds. Regardless, barring an unforeseen natural disaster, the near-term outlook for borrowers remains favorable.

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