Time To Shift Gears

Financing Gauges Begin to Move

Since the 2008 economic recession, self-storage owners have capitalized on a Federal Reserve Funds target rate of nearly zero percent to secure remarkable low-interest loans for acquiring, building, and refinancing their properties. With so much self-storage financing readily available from various capital sources, financing gauges have been set at “full blast” for the past several years, especially for property owners demonstrating optimal occupancy, rental rate, and valuation performance measurements.

Heading into 2017, there is still plenty of capital available for storage owners, but many of the gauges you look to when making financing decisions have started to move and moderate. You’ll need to watch these gauges closely and prepare to shift gears if financing or refinancing your facilities is on the horizon.

Interest Rates Likely To Rise
The first gauge you’ll need to watch is interest rates.

Global economics, volatile bond markets, the movement toward a more protectionist domestic economy, a U.S president-elect with radically different market perspectives than his predecessor, and an increased probability of inflation—they all impact interest rates.

Bond markets immediately reacted to the U.S. presidential election with dropping prices coupled with yields that rose quickly and fairly significantly. In 2017, there are strong indications the Fed will gradually increase short-term interest rates. If these projections hold true, then variable rate loans tied to the Libor or prime rates will immediately rise in sync with Fed target rate changes.

Long-term interest rates are linked to additional factors such as global economics and bond pricing, inflation, demand, and perceived risk. We’re starting the new year on a strong economic footing with low unemployment, a domestic job market at its strongest levels in nearly a decade, rising wages, and promises for a growing economy. Long-term interest rates typically rise during a healthier economy, but with a changing presidential administration and potential shifts in banking and securities regulations, only time will tell which gauges are adjusted in Washington, D.C., that may impact interest rates and capital availability for self-storage owners.

Cap Rates Linked to Interest Rates
A general real estate rule of thumb is that cap rates follow and lag the cost of capital. If interest rates increase or are even expected to rise, it’s likely we’ll see an upward movement in cap rates, but not necessarily a direct correlation. For example, if the cost of capital increases by 0.50 percent, it’s not a given that cap rates will rise at some lesser interval, because cap rates are also highly influenced by relative global real estate returns.

Relative to other commercial real estate sectors, self-storage should remain more stable and recession proof, and continue to have moderate annual revenue growth projections. Even if we experience higher interest rates in 2017, expect self-storage cap rates to move slower than other commercial real estate asset classes.

Underwriting Gauges Hold Steady
The diligence of loan request underwriting and documentation will hold steady in 2017. Credit committees and compliance departments in banks and commercial mortgage-backed securities (CMBS) shops operate with conservative regulatory oversight and guidance. Among many regulations affecting commercial real estate financing decisions are those correlating the volume and level of construction loans relative to the lender’s size, as well as guidance regarding a borrower’s ongoing equity compared to the property’s appraised value.

Further, new risk retention regulations became effective in December 2016 that require CMBS lenders to retain a five percent portion of bonds collateralized by commercial real estate mortgages. This retention requirement will govern credit decisions and increase loan origination costs since it will be built into quoted CMBS loan spreads. It’s premature to tell how these new rules could affect CMBS lenders’ interest rates and refinancing programs, but the number of CMBS lenders could potentially decrease since some may be operationally uncompetitive under the new protocol.

Permanent Loan Terms: Constantly Shifting Gauges
Borrowers sometimes believe that lenders’ gauges have gone haywire because they may offer aggressive terms on one deal but not great options on the next one. With more than $400 billion of commercial loans due to mature in 2017, compared to 2016’s $353 billion, lenders will be selective in pursuing transactions as they monitor their loan portfolio’s mix and performance.

Lenders obviously want and need to have borrower relationships, but changing policies and direction can shift their priorities and financing decisions. Storage facilities located in secondary and tertiary markets often get hit hardest when capital availability changes, resulting in fewer financing options and a relatively higher cost of capital.

Given this shifting marketplace sentiment, it’s important to maintain more than one banking relationship. While interest rates will always be a significant financing decision component, you should also prioritize your other loan objectives and consider lenders who can offer the best overall terms for your broad investment goals. Using an experienced mortgage broker to help you secure competitive quotes can support this process.

Construction Loan Availability: Making The Cut
Thanks to basement-level interest rates in recent years, the entire commercial real estate market has seen more development and construction loans. But with so many of these deals in their pipelines, more lenders are starting to avoid these loan requests. Construction loan terms are also becoming more conservative and selective.

As you prepare a construction or development loan request, consider that lenders will closely evaluate:

• The sponsors’ financial wherewithal
• The sponsors’ real estate and self-storage experience
• The project’s viability, preferably supported by a third-party feasibility study. Lenders will consider a non-third-party study if you can provide unbiased project viability data, including supporting cost schedules, lease-up projections, and sub-market data.

Moderating Performance Velocity
Self-storage velocity gauges are clearly showing signs of moderation as more new product comes to market. Estimates indicate approximately 35 to 40 million square feet of new storage unit space was added in 2016, with an equivalent amount expected to open in 2017. That’s roughly 1,500 new facilities in two years. Rest assured, lenders will consider the new developments’ potential economic impact on your property performance when underwriting loans and determining financing packages.

Self-storage REITs are also reporting a slower velocity of rental increases and increasing concessions for new customer rentals. These lower year-over-year revenue increases are likely a combination of new competition and markets hitting price constraint ceilings following a prolonged stretch of rising rental prices.

While historically high occupancies with upward trending rents bode well when presenting a loan request, lenders can be more cautious with loan terms and leverage if new competition enters or starts building within your immediate locale. Many markets are also experiencing tax increases which, in some cases, can be excessive enough to hit an operator’s bottom line. Permanent financing is based on historic results and will be negatively affected when historic net operating income deteriorates.

Shifting Gears In 2017
While many financial and economic gauges are adjusting to varying degrees, all indications point to 2017 being another strong year for the self-storage industry; just don’t expect things to be as red hot as they’ve been in recent years, since that is no longer sustainable.

We are definitely entering new territory with a potentially rising and volatile cost of funds. Expect industry performance levels to moderate and lenders’ credit standards to hold firm.

As you prepare to shift gears in this changing marketplace, remember to broaden your lending relationships, stay apprised of financing trends, and call upon the experience of experts who can help you navigate the best route to achieving your property and personal investment goals.

With 25 years of experience as a national self-storage mortgage broker and advisor, Neal Gussis is a principal at CCM Commercial Mortgage, where he secures debt and equity financing for commercial real estate properties with a focus on self-storage. During his career, he has been trusted by owners nationwide to secure more than $3 billion of self-storage transactions. Based in Chicago, he can be reached at (224) 938-9419 or ngussis@CCMCommercialMortgage.com.