Much like Cinderella at the ball, self-storage owners are feeling pretty confident and falling in love with the Federal Reserve, as it continues to keep interest rates at historic lows. But midnight is approaching and, at some point, it's back to reality. Luckily, that doesn't mean a life of indentured servitude; but it does mean a potential bump in rates.
Interest payments are often a storage owner's largest monthly expense, so even a modest increase can have a significant effect on the bottom line. While it may feel like you're the darling of the ball, the clock is ticking, as Federal Reserve Chair Janet Yellen signals an end to quantitative easing and an increase in the federal funds rate.
In today's market, there are some very attractive rates and terms. Commercial mortgage-backed security (CMBS) debt is a particularly attractive option, offering 10-year, non-recourse, fixed-rate debt with a 30-year amortization and an interest-only period for loans as small as $2 million. Rates generally range from 4.25 percent to 5 percent, with proceeds up to 75 percent loan-to-value (LTV). Prepayment penalties typically take the form of defeasance with open prepay during the last two to three months of the loan.
Life insurance companies are also offering very competitive rates and terms, often on a non-recourse basis. While these companies are generally more conservative in proceeds and more selective for the properties in which they lend, they make up for it with very competitive rates. The most selective assets and borrowers benefit from rates in the mid 3 percent to 4 percent range. Life companies offer a standard 10-year term and 25- to 30-year amortization structure, but also feature fully amortizing loans with a 15/15 and 20/20 structure.
As mentioned, these lenders are selective and prefer quality assets in primary and secondary markets. Loans are lower leverage in nature, with typical LTVs at 65 percent. Life companies are also attractive due to the flexible prepayment options they offer.
Local, regional and national banks also present an attractive option for borrowers looking for more flexibility. Loans terms max at five to seven years, with a 25-year amortization and LTV capped at 75 percent. Banks offer both fixed- and floating-rate options, with floating rates from 2.5 percent for highly capitalized borrowers to the high 3 percent range for more traditional borrowers.
Fixed-rate deals are in the low 4 percent range and generally offer interest-only options. Prepayment penalties are often on a declining basis, with 5 percent in year one, 4 percent in year two, 3 percent in year three, two percent in year four and 1 percent in year five being the most common.
Keep in mind bankers are more relationship-based and borrowers should be prepared to have operating accounts and/or other significant depository relationships in place with the lender. Credit unions offer similar rates and terms, but due to federal regulations are often required to offer open prepay.
Small Business Administration (SBA) loans are another popular option for self-storage owners. There are two types of loans available to this industry: SBA 7a and SBA 504.
The 7a program is most commonly structured with a prime-based rate that resets quarterly and a fully amortizing 25-year loan. This program is designed for borrowers who typically have an LTV in excess of 80 percent, want to refinance, and have a shorter holding period.
SBA 504 is a fixed-rate program that carries a rather steep 10-year prepayment penalty. The 504 program currently doesn't allow for refinance and is only available for acquisition financing.
Perhaps these rates and terms don't sound that impressive because we've been spoiled by a relatively low interest-rate environment over the past few years. However, when you compare rates over the past 50 years, the story is a little different. Ten-year money is often priced over 10-Year Treasuries. The chart below shows the history of nominal interest rate on 10-Year Treasuries.
As you can see, we're experiencing some of the lowest 10-Year Treasury rates over the course of the past 50 years. Of course, there's a spread premium above the Treasury that's specific to every transaction, but this presents a general look at rate movements historically.
The Federal Reserve has a significant effect on interest rates, both short- and long-term. The federal funds rate is the rate at which banks can borrow from the Federal Reserve. As it becomes more costly for banks to borrow, it becomes more costly for consumers to borrow. Via the federal funds rate, the Federal Reserve has a direct impact on short-term interest rates. Changes to those rates often mirror changes to long-term interest rates. Here's that same historical 10-year Treasury rate graph with the federal funds rate superimposed.
There certainly are some similarities in rate movements historically and, for those statistics majors out there, the correlation coefficient is .897, meaning a relatively high correlation between rates. The Fed has intimated that it will start to raise the federal funds rate once certain, undisclosed macroeconomic metrics have been met. Many are predicting it will begin to rise in early 2015.
Additionally, the Fed has impacted long-term rates through its quantitative-easing program by which it purchases Treasury bonds in an effort to keep long-term rates artificially low and support economic growth. However, the Fed has been tapering its bond purchases and, as of April 2014, is purchasing $55 billion per month, a decrease of $10 billion from the previous month. If this tapering continues, the Federal Reserve will no longer be buying Treasury bonds by the end of 2014. With less demand for bonds from the government, rates should rise.
What does this all mean in real terms? Let's imagine a realistic 100-base point increase in rates from 4.5 percent to 5.5 percent on a $3 million loan.
A mere 1 percent increase in rates would result in an additional $22,000 in annual debt-service payments, or approximately $222,000, over the course of the 10-year loan. Additionally, the principal balance on the loan will be $73,500 higher when the loan comes due because more of the monthly payment is dedicated to interest and less to the principal paydown. As you can see, rates matter significantly.
The good news for storage owners is lenders generally look favorably on the industry as an asset class. Thanks to month-to-month leases and high operating margins, self-storage is better able to withstand changes in market conditions. The industry proved to be very resilient through the turbulent times from 2008 to 2012. The graph below highlights the historical default rate on CMBS debt for different commercial real estate asset classes over the past 14 years.
As you can see, self-storage has consistently had the lowest default rate of any asset class. Previously considered a "niche" asset by lenders and CMBS bond investors, many now understand self-storage metrics and see the value in lending on it to help minimize volatility in their portfolio.
Another turning point for self-storage as an asset class occurred in January 2012 with the cover-page article in "The Wall Street Journal" titled, "Storage REITs Enjoy a Boom," chronicling the incredible success of the four self-storage real estate investment trusts (REITs) over the past few years, especially compared to the dismal performance of other REIT asset classes. Lenders are taking note. Self-storage is now a well-respected asset class and a sought after component of many lending portfolios.
It may make sense to refinance in this favorable market before rates begin to rise, as many economists believe they will. By historical standards, there's certainly more room for rates to move up than down. Today, storage owners have the ability to lock in a fixed-rate loan for 10 years, which can potentially save hundreds of thousands of dollars and provide a competitive advantage over less savvy competitors. Midnight is fast approaching, and it's time to lock down your Prince Charming.Devin Huber is a principal at The BSC Group, which offers financial and loan advisory, mortgage-brokerage and loan-workout solutions to commercial real estate property owners and investors, with a special emphasis on the self-storage market. Prior to helping found The BSC Group, Huber was a senior vice president at Beacon Realty Capital and a key member of the firm's Self Storage Group. To reach him, call 800.605.7880; e-mail firstname.lastname@example.org; visit www.thebscgroup.com.
This article has been reprinted with permission from Inside Self-Storage, the premier magazine of self-storage professionals. For information, visit www.insideselfstorage.com.
The BSC Group has been voted Best of Business - Finance for five years running by the readers of Inside Self-Storage.