A View From the Street: The Bumpy Ride Is Not Over Yet

January, 2008

For the past year, this bi-monthly column has provided readers with an outlook on real estate and financing developments and how they can affect the self-storage business. Now that it's a new year, let's look ahead to see what 2008 may bring for our industry.

Before we launch ahead, though, we need to take one last peek at what occurred on one day in 2007 because it had a profound effect on the self-storage industry, and will continue to do so in 2008.

A Day to Remember

The year 2007 started out well enough for the self-storage real estate and financing sectors. We cruised through the first quarter, enjoying strong construction, acquisition and lending activity. And the industry continued along its five-year growth trajectory, thanks, in part, to unprecedented access to cheap and aggressive capital that allowed property owners and investors to fund their investments.

Residential sub-prime mortgage problems started to come to light in the first quarter; at that point, they were not yet affecting commercial real estate. But with the passing of April 11 came a pendulum swing in the capital markets that has created a bumpier ride for self-storage real estate investors and owners ever since. On that day we witnessed how a single event can completely reshape the future.

What happened? Rating agency Moody's Investors Service declared that lax underwriting on commercial mortgage backed securities (CMBS) loans had increased investors' risk, and it vowed to increase subordination levels on future transactions. Other rating agencies immediately followed suit. Increased subordination levels raise a lender's cost of capital because a higher percentage of its mortgage pools must be sold to bondholders, requiring a higher investment return.

As rating agencies intended, CMBS lenders reacted almost overnight by tightening underwriting standards, scaling back or eliminating interest-only loan periods, boosting equity requirements, and effectively reducing proceeds available on self-storage loans.

The capita-market storm gained ferocity in July as buyers of the riskier investment bond tranches, known as B-piece buyers, nearly all retreated from the market and stopped purchasing CMBS investments. This snowball effect created significant obstacles for CMBS lenders because it caused a huge gap in the demand side of the equation.

Because of this, bond investors now require a higher return on securitized debt pools, which, in turn, increases the cost of capital and decreases the amount investors can pay for self-storage properties. As a result, spreads in the conduit market have spiked to 195 to 225 basis points over the 10-year Treasury; debt-service coverage ratios (DSCRs) have jumped to 1.25; the collateralized debt obligation (CDO) market has essentially collapsed; and cap rates are rising for properties, requiring a new debt structure.

The immediate and real effect of this correction ultimately affects the bottom line of any commercial real estate enterprise. In the case of our industry, we saw a dramatic slowdown in real estate transactions in the fourth quarter of 2007.

Opportunity Knocks

While it may seem as if the past year has been dominated by doom and gloom, rest assured it hasn't. Corrections like these are an inevitable part of a free-market economy and are actually healthy for the long-term viability of the finance sector.

Many positive signs have been posted that should hold your view in the coming months and work to your advantage:

  1. The underlying fundamentals of the self-storage asset class remain strong. Self-storage is still at the top of any commercial real estate class when measured by its very low default rates (less than .5 percent for CMBS). That alone will help support investor interest in self-storage properties this year.
  2. The money and demand for well-maintained self-storage properties remain strong. It's not the amount of acquisition dollars that has changed in recent months, but rather the property debt these dollars can acquire. The underlying problem is the gap between buyers and sellers in terms of value. Once this gap is better aligned, we can expect to see more real estate movement.
  3. Occupancy rates remain high nationwide. Correspondingly, facility revenues are increasing. Further, as more homeowners affected by the sub-prime-market collapse search for new living arrangements, the demand for self-storage facilities will continue to grow.
  4. Property owners who capitalized on the low fixed-interest debt market and have a high loan-to-value ratio in their financing have actually created value with their property debt. An investor can assume this low interest rate and still make the numbers work, in turn paying a more aggressive cap rate. By doing so, investors gain the advantage of achieving a debt structure that is no longer available due to recent lending-program changes.
  5. Property owners who owned self-storage before the boom can still sell their properties for a significant return on their original investment.
  6. Institutional investors continue to be interested in high-quality self-storage assets. They recognize the value of the asset class compared to other commercial property types.
  7. The capital markets will continue to adjust over time and find new levels of equilibrium and profitability. CMBS lenders in particular are adjusting deal terms relating to interest-rate and loan provisions to meet new levels of acceptable credit risk and profit return. We have seen buyers of CMBS pools return to the market and begin to provide additional liquidity, which has caused spreads to tighten relative to the market peak experienced in August.
  8. Because B-piece buyers continue to demand higher yields, you shouldn't expect spreads to return to the low 100s seen in 2007's first quarter. However, current spreads are close to historical averages and reflect the risk reward associated with commercial mortgage debt.
  9. During the peak of the credit crunch, several lenders retreated to the sidelines, with others completely shaken out of the market. We expect sidelined lenders to be ready and willing to deploy their capital in 2008. However, origination volumes will decrease significantly for CMBS lenders, with the expectation that insurance companies and traditional banks will absorb this volume.
  10. We will not see loan structures in 2008 equal those experienced in early 2007; however, deals are still closing with attractive terms. We expect to see LTV ratios up to 80 percent, DSCRs as low as 1.20, and loans featuring 30-year amortization and interest-only periods for a few years.

On the negative side, as buyers continue to return to the CMBS market, interest rates are not guaranteed to decrease from today's level. The stock market's continued ascent, Fed debate on whether to reduce interest rates, and the weak U.S. dollar all point toward an increase in U.S. Treasury rates. Adding to this is a recession risk, which would negatively affect all commercial paper.

Sit Tight

We predict the first six months of this year will focus our industry's direction from a value perspective. Once their confidence is restored and credit-market volatility settles, investors will continue to buy CMBS deals. We anticipate self-storage, because of its proven stability, will continue to be a desirable asset. However, until investor confidence is restored, we will see cap rates increase similar to interest rates.

Don't unbuckle your seat belts just yet; the capital-market-volatility ride is not over. But there are positive signs that should help the real estate and financing markets regain some of their traction and momentum from previous years.

Devin Huber is principal with The BSC Group.

Doug McCarron is a partner at Storage Investment Advisors.

Inside Self-Storage January 2008

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.

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