The economic recovery is in full swing, and the gradual unwinding of quantitative easing is inevitable. What does this mean for self-storage investors? The time to seek money is now.
In an ironic twist of fate, on the heels of arguably the greatest real estate recession since the Great Depression, the last 18 months of recovery have presented real estate investors with an unparalleled period of liquidity and low-cost borrowing. During this global financial crisis, the Federal Reserve took unprecedented actions, implementing monetary policies that restrained the federal funds rate to near zero, while simultaneously infusing massive volumes of capital into the market.
These actions kept mortgage-borrowing rates at artificially low levels, effectively bolstering the mortgage market. The removal of near-term interest rate risk aided in the refinance and restructuring of maturing and problem loans for borrowers and lenders, thereby enabling capitalization (cap) rates and real estate values to sustain a much-needed and expeditious recovery.
Today the economic recovery appears to be in full swing, and this strengthening of the economy has tremendous implications for upward pressure on interest rates. Last summer, Federal Reserve Chairman Ben Bernanke hinted that the Federal Reserve would soon begin the process of unwinding the quantitative easing by gradually decreasing bond purchases and letting securities mature. These insightful comments rightfully raised caution among the investment community, sparking an immediate spike in Treasury rates.
Specifically, within a short 60-day period last summer, the 10-Year Treasury increased more than 100 basis points, or more than 1 percent. As a result, the borrowing rates on 10-year mortgages went from the low 4 percent to the low 5 percent range in the blink of an eye.
The Fed has since softened its stance on easing, and Treasury rates have responded by settling a bit, currently hovering around 2.65 percent, which is well below its long-term average and not too far off from historical lows. Nonetheless, this gradual unwinding is inevitable, and there's widespread speculation that it could begin within the year.
Indicative of a stronger economy, the withdrawal of Fed monetary support will likely exert tremendous upward pressure on interest rates. In fact, the biggest looming unknown appears to be not "if" but "when" this upward rate movement will begin in earnest. To some, the upward movement witnessed this summer was the beginning of the end of the unprecedented low interest-rate borrowing window. Regardless, the tapering of the Fed's quantitative easing is expected and should mark a return to a more normal credit environment, which is far less reliant on artificial policy intervention.
Though it will raise some headwinds for investors in the near term, positive economic trends should ultimately help boost commercial real estate performance. Conventional wisdom would dictate that a rise in interest rates would instigate an increase in cap rates, which ultimately undermines property values and weakens commercial real estate returns. There's little doubt that rising interest rates inevitably exert upward pressure on cap rates.
Nonetheless, during inflationary periods, property owners benefit from an ability to push rents, resulting in increased property values through an increasing net operating income (NOI). After all, it's the very hybrid nature of commercial real estate that makes it such a compelling investment option, with its steady and bond-like cash flow component, even during economic downturns, as well as an appreciation component that often acts as an inflationary hedge.
The inherent nature of self-storage and its short-term leasing only provides a further competitive advantage in this regard, by effectively affording investors in this asset class the flexibility to quickly and frequently adjust market rates through prudent revenue-management practice, complemented by proven recession-resistant demand characteristics for the product.
Although the debt and equity markets are once again on solid footing, the credit environment is not without risk, and volatility should always be expected. There are still many factors looming today, far beyond the layman's control, which bring a level of uncertainty that muddies the water. This includes looming debt-ceiling discussions, geopolitical tensions in the Middle East, the effects of government sequestration, and declines in federal spending-all of which could hamper economic growth and disrupt the financial markets.
Regardless, the current demand for all commercial real estate, including self-storage, is being supported by the strengthening economy. Occupancy and rent growth gains remain strong, and supply risks, while increasing, remain minimal. Mortgage investors continue to have sharp demand for commercial-mortgage bonds, and credit spreads have remained stable while the Treasury market rallies, keeping borrowing rates near historical lows at present.
For the time being the historic window of low interest-rate borrowing remains very much open. If you haven't done so already, perhaps it's time to listen to the sweet sound of opportunity knocking and take advantage of this chance to refinance your assets into a long-term debt product that will ultimately help insulate you from any negative effects of a rising interest-rate environment!
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. He can be reached at 312.207.8237; 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.