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.
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.
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:
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.
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.
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 six years running by the readers of Inside Self-Storage.