Weathering the Storm

April, 2012

To hear meteorologists talk about it, winter in Chicago this year was going to be bitterly intolerable. In November 2011, experts filled newspapers with warnings of a brutally cold and snowy winter to come, with record-breaking lows and abnormally high levels of precipitation. 2011-2012 was meant to be the worst winter in decades, and the weathermen had the latest computer simulations to back up their predictions. One meteorologist went as far as to say "people in Chicago are going to want to move after this winter." (1)

It is now February 2012, and there was no mass exodus from the Midwest. This winter has been mild; so far, it's been the ninth warmest winter on record with only one significant snowfall to date. The weathermen have changed their tune, describing the situation as a "snow drought," lamenting on behalf of all Midwestern snow lovers. (2)

When talking with storage owners who are interested in refinancing or acquiring a new facility, the first question I am often asked is, "where are rates at these days?" Based on historical standards, the answer is that rates are currently low. But the question for many is whether the recent low-rate environment is an abnormal period of sustained low interest rates, ready to revert back to the long-term "mean interest rate," or whether we have entered a "new norm," where all-in rates of 4-6% will continue indefinitely. It's an important issue for storage owners because interest rates can limit your proceeds, creating a potential shortfall when you refinance. Furthermore, market interest rates and asset value are inversely related, such that higher interest rates on debt push up cap rates and thus decrease value. Because interest rates are so important to the financeability and value of a storage property, it is important to have a sense where rates are today relative to where they will be in the short and long term. Rather than opine on where rates are headed, I will present the facts and let you, the reader, make your own conclusions. Bear in mind, though, that your well-founded analyses could still turn out to be as erroneous as all those predictions about this year's bitter Chicago winter.

Index Rates

First, a little Econ 101 review. Commercial mortgage interest rates are a function of an index rate plus a specific credit risk spread. The index rate is generally Prime or 1-month LIBOR for floating rate mortgages and the corresponding treasury rate for fixed rate mortgages (the 5 year treasury rate for 5 year fixed rate money, etc). (3) Prime and 1-month LIBOR rates are highly correlated with the Fed Funds rate, the overnight rate at which banks lend to each other in order to meet mandated reserve requirements. That rate is determined by the Federal Reserve and is currently at a very low 0.25%. As the Fed Fund rate moves up or down, both Prime and LIBOR rates generally move in lockstep, with LIBOR at a similar rate and Prime at a 300 bps (3.0%) spread. Since the beginning of 2011, the 1-month LIBOR has varied from 0.18% to 0.30%, very close to the Fed Funds rate. Similarly, the Prime rate has not varied from its 300 bps spread and has been at 3.25% since January 2009.

Treasuries are a bit more complicated. While yields on short-term U.S. Treasuries of 6-months or less are highly correlated to the Fed Funds rate, yields on five-, seven-, and ten-year treasuries used for commercial mortgages have less to do with the Fed Funds rate and are rather affected by a multitude of factors. Most recently, during the world recession of 2008-2010, there was a "flight to safety." Investors were fearful of placing bets on businesses, homeowners, and other potential investment outlets, so they stored their money in the world's only "risk-free" asset, U.S. Treasury bonds. This, in turn, drove up bond prices and correspondingly drove down bond yields. Other global investors see stability in Treasuries. The Eurozone, for example, is undergoing a period of turbulence, and some global investors see stability in the U.S. dollar. Other developing economies see annual inflation at 10% or more and are able to store the value of their money in dollar-denominated Treasuries rather than let their foreign-denominated investment depreciate. The point is, U.S. Treasuries are attractive to investors for many different reasons - as a place to store assets, as a diversifying agent, as a currency hedge, etc. - so much so that it is hard to predict with certainty what may trigger a rise or fall in treasuries. Just as meteorologists must make predictions in an environment with many variables, Treasury prognosticators cannot account for the infinite variables that determine Treasury yields. Thus there is no way to predict with certainty where Treasury yields will trade six weeks or six years from now.

Currently, the Fed Funds rate, LIBOR, and Prime, as well as 5-year and 10-year treasury yields are at historical lows (see graph below). (4)

Some argue that these low rates are not sustainable and must eventually rise to historical averages (see table below), while others see this as new era where low rates are the new norm. (5)

Inflation and Interest Rates

Inflation is the one factor that will likely cause all index rates, both short- and long-term, to rise. The Federal Reserve's goal is to "promote maximum employment, production, and price stability." (6) This is often a delicate balance. If rates are kept low for an extended period of time in order to aid economic growth, there is the possibility that the money supply increases such that too many dollars are chasing too few goods, creating an inflationary environment. Currently, it seems that the main priority is job creation and economic growth; on January 25, 2012, the Federal Reserve released a statement that it expects to keep the Fed Funds rate near zero percent at least through late 2014. However, if the money supply increases, creating a rise in the prices of necessary goods, the Fed may consider raising the Fed Funds rate to encourage people to save rather than spend, and thus decrease the money supply to counter inflation. As mentioned before, a rise in the Fed Funds corresponds to a rise in Prime, LIBOR, and short-term treasuries.

Regardless of the Fed's behavior, there is a relationship between inflation and interest rate. From an investor's perspective, they are going to need to be compensated accordingly if the value of their dollar is worth significantly less a year from now than it is today. Thus, as inflation increases above the typical 2% annual goal, investors are going to demand higher rates of compensation to offset that inflation. As such, whether floating or fixed-rate debt, storage owners can expect their interest rate to increase if there are inflationary pressures. Shock events - oftentimes outside the control of policymakers - that sharply increase the price of necessary goods like food, housing, and energy can trigger inflation. Potential military strikes in Iran and their retaliatory threat to close the Strait of Hormuz and an increase in climate-change-induced natural disasters could trigger spikes in the price of energy and food. With so much pressure on prices, it's not hard to imagine how the United States could see a period of inflation.

So, will inflation be an issue in 2012 and beyond? This seems more like a question for our trusty weatherman; time to examine the data so you can create your own seven day forecast.

Firstly, let's take a look at Treasury Inflation-Protected Securities (TIPS), which are bi-annually adjusted for inflation at the CPI rate. With 10-year Treasuries offering yields of 1.99% and TIPS selling at a -0.22% yield, the difference is the market's expected average annual inflation rate for the next 10 years, in this case 2.21%. The 5-year TIPS are trading at a 1.97% yield premium over traditional treasuries. Considering historic inflation has hovered around 2%, the market doesn't seem to view inflation as a significant factor.

Secondly, the yield curve often offers hints at the market's expectations for growth and inflation. The yield curve highlights the relationship between interest rates and maturities and it's common for shorter-term rates to be lower than long-term rates. The yield curve is therefore generally positively slopped. When this curve is sharply positive, the market weatherman is generally forecasting growth with a chance of inflation. When the yield curve is inverted, with short-term rates higher than long-term rates, that same weatherman sees a slowing economy with little likelihood of inflation. The current yield curve is relatively steep by most standards (see below).

For example, the spread between the 3-month Treasury bond yield and 20-year treasury bond yield has averaged around 200 bps. When it surpasses this amount, there is the expectation of growth and the potential for inflation. The highest recorded spread was 292 bps and today that spread is 271 bps. (7) It's hard to draw definitive conclusions, but there does seem to be signs that the market perceives some inflation risk.

Credit Risk Spread

The second component of commercial mortgage interest rates is the credit spread. The credit spread is the risk premium above the treasury yield that a lender will require to compensate them for the risk associated with a particular commercial real estate transaction. The spread is affected by both property level metrics and macro-level economics. On the macro-level, as the economy grows and employment increases, there will be renewed confidence in commercial real estate. Conversely, there are, of course, national and international events that push credit spreads higher across the board. The depreciation in the housing market and the subsequent collapse of Lehman Brothers created a market-wide knee-jerk reaction in 2008. CMBS bond buyers were fearful of investing in commercial real estate and spreads on those bonds skyrocketed from 30 bps to nearly 1,200 bps (see graph below). While this reflects the risk premium placed on the CMBS bond market, it acts as a proxy for commercial real estate credit risk spreads. So clearly, market shocks can play a role in determining credit risk spread.

In addition to the macro-economic metrics that affect credit spread, you also have property- and borrower-specific drivers playing a role. For instance, the leverage of the loan, the location of the real estate, the consistency of the income stream, the experience of the operator, and the strength of the sponsor all affect the credit spread. In the lending industry, this is known as risk-based pricing. This can be illustrated by the fact that a large self-storage portfolio, in a top-tier MSA, requiring leverage less than 60% with an institutional sponsor, is going to have an all-in coupon rate significantly lower than that of a small one-off property, in a tertiary market requiring 75% leverage. Not surprisingly, credit spread has many of the same characteristics as a cap rate. The riskier the asset or loan, the higher the cap rate or credit spread.

Implications for Storage Owners

Cap Rates & Value

So what does all this mean for storage owners? Let's run through a hypothetical scenario whereby rates increase across the market from 5% to 7%. While 200 bps may not seem apocalyptic, it can be for some storage owners on the margin. As rates rise, self-storage values will almost certainly decrease. The cap rate spread is the difference between cap rates and the corresponding "risk free" rate, usually the 10-year treasury rate. As interest rates increase, cap rates increase accordingly. Consider the investor's perspective- in order for investors to meet their target IRRs during a higher interest rate environment, they must purchase the target asset at a lower price to compensate for the increased price of the debt. Cap rates increase in order for investors to accommodate the new interest rate environment, and values, in turn, fall. However, because storage REITs (or other low leverage buyers) can purchase with cash, the effect of interest rates may be tempered in markets where REITs compete, namely primary markets with strong demographics. Secondary and tertiary markets will be more susceptible to affects in value due to increased interest rates.

Refinancing - Potential Loan Constraints - The Equity Gap

Therefore, borrowers facing a refinance may be both cash-flow and value constrained. In today's environment, lenders generally require a minimum debt service coverage ratio (net cash flow/debt service) in the 1.50x range. With constant net cash flow and higher annual debt service, thanks to higher interest rates, borrowers may be limited in terms of what they can borrow. For example, imagine a $3,000,000 self-storage acquisition that collects $225,000 in NOI (capped at 7.5%). At a 70% LTV constraint, the borrower is limited to $2,100,000 in proceeds. Assuming a 5% interest rate, the debt service coverage ratio (DSCR) is at a comfortable 1.53x. However, at a 7% interest rate, the DSCR shrinks to 1.26x, not enough cash flow coverage for many lenders. Now proceeds are constrained by cash flow. Lenders requiring 1.50x coverage will only lend approximately $1,770,000, requiring an additional $370,000 in equity that would previously have been funded as debt. Similarly, due to the increase in interest rates, one would expect a corresponding increase in cap rates. In the case below, we assume that a 200 bps increase in interest rates translates to a 150 bps increase in cap rate. Because of the new higher cap rate, value falls to $2,500,000 and borrowers are now constrained by loan-to-value as well. The new loan to value constraint has left the borrower $350,000 short. This may seem dramatic, but it is a realistic possibility if rates were to noticeably increase.

Inflation & Dynamic Pricing

It is important to consider the cause of the interest rate increase as well. If it is inflationary pressure causing rates to rise, this can sometimes work in an owner's favor. Storage pricing is today very dynamic. The most sophisticated operators change their prices daily and offer different rates to customers that call the store, search on the internet, and walk in the office. Furthermore, many operators offer systematic rate hikes as local market supply and demand dictates. Because of this, storage owners are better able to respond in an inflationary environment by increasing rates accordingly. Compare storage owners to office property owners, whose tenants sign long-term leases that cannot be adjusted during an inflationary environment. While it is true that storage expenses will likely increase at a similar rate, the bottom-line NOI should grow with inflation, helping to offset increases in cap rates and help stabilize values.

While this all somewhat technical, it is important for storage owners to have a sense of where rates are headed. If you conclude that rates are abnormally low and will likely increase, it would be wise to lock in long-term, fixed-rate financing today. If however the conclusion is that we have entered a new era where rates are permanently low and may even go lower, it may be wise to wait and see. Even for those that believe rates are low, there is 10-year, fixed-rate debt available with no prepayment penalty, creating a nice hedge against higher rates while allowing for early refinance if rates decrease. It's important to have a sense of where rates are today relative to where they will be in the future in order to limit one's financing costs and protect against the effects of a higher rate environment.

Experts will offer their opinions about the future of interest rates, but the truth is that there is no telling whether the current period of low interest rates is just an abnormal dip or, in fact, the "new norm". In this way, predicting the future movements in interest rates is like predicting the weather. 2011-2012 didn't turn out to be a brutal winter by any measure, but that won't stop the meteorologists voicing their predictions next November. The lesson is: do your homework, understand the market, and create a strategy that fits your financing goals.


[1] Heather Buchman. (2011, Oct) AccuWeather.com Winter 2011-2012 Forecast: Another Brutal One. AccuWeather.com. Retrieved from http://www.accuweather.com/en/weather-news/accuweathercom-winter-20112012/55890

[2] Tim Magill. (2012, Feb) Tim's Weather World: No doubt snow drought will continue. Chicago Weather Center. Retrieved from http://blog.chicagoweathercenter.com/

[3] Note: CMBS rates are generally priced at the corresponding Treasury swap rate.

[4] Note that the Fed Funds rate presented is the weighted average of rates on brokered trades, not the Fed Funds target rate as set by the Federal Reserve.

[5] Historical averages date back to 1954.

[6] As outlined in the 1977 Federal Reserve Act.

[7] As of 2/20/2012

Mini-Storage Messenger April 2012

This article has been reprinted with permission from Mini-Storage Messenger.

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