The Interest Rate Gamble

September, 2014

Safe Betting Strategies for The Interest Rate Gamble

Although the economic recovery is not yet finished, many of the key indicators would suggest that it is well on its way. Interest rates remain near historic lows, yet the unemployment rate is improving 18 months ahead of schedule. Invariably, the begging question becomes: how long can these historically low rates last?

Although it remains uncertain how soon and at what pace rates will rise, if you listen closely you can clearly hear the Fed's chatter indicating that rates could start creeping higher in the next 9-12 months. While the timing will depend largely on the speed of the recovery, invariably it appears to be a question of when, and not if.

Even if you are a gambler, now is the time to act. The window of opportunity is still wide open, so take the sure bet and seize this opportunity to evaluate your options and develop a sound strategy that will maximize your investment and insulate you from the looming increase in interest rates.

The Markers

Two of the primary markers that the Fed looks at closely when considering monetary policy are unemployment and inflation, both of which seem to be improving. The previously stated goal of the Federal Open Market Committee (FOMC) is to keep interest rates low until unemployment falls below 6 percent or inflation eclipses 2 percent, at which time it would begin to consider raising rates.

With respect to unemployment, the economy is getting very close to the stated 6 percent threshold. Consider that in the month of July, employers added 288,000 jobs, which was a healthy increase over the consensus prediction of 215k. The Q2 average is now at 272k, outdoing the last 12-month average of 201k. In July alone, the Unemployment Rate has dropped nationally to 6.1 % compared to the 6.3 % represented in June; this is the lowest it has been since September 2008.

On the inflationary front, the Federal Reserve currently maintains that inflation remains below the range where it would consider raising interest rates. Despite that, the personal consumption expenditures index, which is the central bank's favored inflation gauge, is up 1.6 percent on an annualized basis, according to the latest reading. In addition, during the recent earnings season companies across various industry groups-from food to technology to health care-are raising costs for the consumer. Included among these are companies such as Hershey, M&M Mars, Kraft, Starbucks, and Chipotle, all of which announced that they are raising prices for consumers. When prices rise for the consumer, it is a clear sign that inflationary pressures are mounting.

Interpreting the Signs

Although we may still be 9-12 months out from a formal rate increase, if you read carefully between the lines it would appear one is definitely on the horizon. At recent meetings one FOMC voting member indicated a preference to raise rates earlier than expected but at a gradual pace. Another reiterated his view that the Fed will begin hiking in mid-2015. A third suggested that a hike in Q1 2015 would be dependent on improvement in economic and labor market conditions, a trend that appears to be playing out. Based on these comments it would certainly appear that there is an awful lot of Fed-chatter around a 2015 rate hike.

The bottom line is that if labor markets continue to improve or inflation accelerates, you can safely bet that an increase will come sooner than later.

Place Your Bet

The strengthening economy is increasing the current demand for commercial real estate assets, self-storage included. During inflationary periods, property owners have a leg-up as they can push rent, which theoretically results in an increase in property value. The offset, however, is that interest rates and cap rates are highly correlated; when interest rates increase then cap rates should also increase, thus constraining the increased valuation. In addition, if your interest rate is not fixed for an extended period, at some point your interest rate on debt will adjust, thereby increasing debt service and marginalizing the cash flow delta. For investors that are not careful, increasing cap rates and the rising cost of debt will offset many of the benefits of inflationary rental rates increases.

Regardless of your strategy, if you are a real estate investor the next 6 months presents an excellent opportunity to evaluate your options, and act. Given the current cost of debt and plentiful equity looking to invest, cap rates are extremely aggressive; if you are looking to sell in the near term it is a great time to talk to an investment sales broker and obtain an opinion of value. Alternatively, if you are an investor with a long-term hold strategy, now is the ideal time to consider your refinance options. Interest rates on long-term debt products are extremely low, and lenders are aggressively seeking deals. CMBS lenders, for instance, are offering 10 year, fixed rate, nonrecourse money around 4.5%. Insurance companies and banks are also offering very competitive long-term rates.

Going forward you should expect volatility and a rise in interest rates. Given that interest rates remain historically low, the potential to lock-in a great deal over the next six months presents an excellent opportunity for investors to take advantage of the opportunities in the market. Don't be passive. Make the safe bet to benefit from historically low rates and corresponding aggressive cap rates to enjoy your winning hand for years to come.

Inside Self-Storage September 2014

This article was reprinted with permission from Inside Self-Storage, one of the leading magazines of self-storage professionals. For information, visit www.insideselfstorage.com.

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