The sharp rise in interest rates since the start of the year has surprised many. Amid the coronavirus pandemic, policymakers have made a concerted effort to keep interest rates low to fuel a recovery in its economic effects. Fast forward to today, and it’s a different picture. With unemployment near record lows, labor shortages, ongoing supply chain issues, huge fuel price increases and strong consumer demand for goods and services, we are now plagued by inflation not seen in over 40 years.
The rise in interest rates was fueled by the actions of the 12-member Federal Open Market Committee (FOMC), which controls the federal funds rate. This is the interest rate at which depository institutions lend Federal Reserve balances to other depository institutions overnight. Changes in this rate trigger a chain of events that affect other short-term interest rates, exchange rates, long-term interest rates, and the amount of money and credit available. Ultimately, all of this influences a range of economic variables, including employment, production, and the prices of goods and services.
Let’s take a look at how all of this relates to loan availability for self-storage properties and what rates borrowers can expect when looking for financing.
Availability of funding
Unlike other market cycles, like the 2008 recession, when capital was hard to come by at all costs, financing is readily available from all types of funding sources for all types of loan applications. Whether you are looking for cash for a development, acquisition or expansion, or perhaps looking to refinance, there are lenders ready to offer you options.
Self-storage has been a benefactor of consumer behavior during the pandemic. This is supported by quarterly announcements from the industry’s real estate investment trusts, all of which reported healthy occupancy rates in the mid-1990s as well as year-over-year revenue increases of more than 15%. This kind of performance once again shows the resilience of self-storage through tough cycles. Coming out of the pandemic, it is seen by many lending sources as a preferred property type, alongside the industrial and multi-family sectors.
Fed funds rate hike
Floating rate loans are usually tied to indexes that move almost in sync with the movement of the fed funds rate. For example, see the following table:
If the FOMC continues to raise the federal funds rate, a borrower who has a variable rate loan is likely to see their interest rate increase in steps similar to Fed increases. There is a greater than 70% chance that the federal funds rate will hit 2.25% by the end of the year, according to the Chicago Merchandise Exchange FedWatch Tool.
As things stand, there can be many instances where variable rate loans have lower interest rates than comparative fixed rate loans. However, these scenarios could reverse if the FOMC executes on its plan to continue raising the fed funds rate. For reference, most construction loans are variable rate (and interest only) during construction as well as 12 to 36 months during lease. If you have or plan to have a variable rate loan, it is prudent to budget for increases in interest charges over the remaining term. For construction financing, be sure to create an adequate interest reserve in the loan.
Interest in fixed rate mortgages has also increased since the start of the year. In general, a loan that probably would have had a fixed interest rate quoted between 3.25% and 3.50% six months ago would probably be quoted between 4.5% and 5.5% today. Many fixed rate loans are priced based on a spread over the relative duration of Treasury or SOFR rate indices.
It is important to note that each loan transaction has unique characteristics and is priced accordingly. There are also a myriad of other terms to consider when choosing an option that best suits your investment goals. The Treasury yield does not necessarily move in sync with the FOMC actions. In fact, in May, the 10-year Treasury yield fell more than 0.25%. Moreover, at the end of May, the yield curve was flat, with yields on 5- and 10-year Treasury bills being almost identical.
Loan size to value
Since self-storage is in high demand as a type of commercial property, ranging from traditional facilities in rural communities to multi-storey Class A institutional properties on prime real estate in infill urban areas, valuations and sales remain extremely aggressive. The more forcefully a property is purchased relative to existing cash flows (i.e. the lower the cap rate), the more difficult it is to receive maximum proceeds based on loan-to-value (LTV) parameters ) max.
Loans for acquisitions and refinancings are mainly underwritten and dimensioned according to historical operating results, with a minimum debt service coverage (DSC). This is calculated by dividing the net operating income (NOI) by the debt payment. The minimum DSC generally ranges from 1.2 to 1.35. With rising rates and historically low valuations, these constraints can limit loan sizes to well below the maximum LTV.
To give some perspective, a termsheet can have a maximum LTV of 75% and a minimum DSC of 1.3. The resulting loan could potentially achieve an LTV of 55% to 60%, well below the maximum LTV of 75% based on the interest rate, amortization, and capitalization rate used during valuation.
Reduced prepayment penalties
If you have self-storage facilities funded by commercial mortgage-backed securities (CMBS) or have a loan with a matching swap instrument, rising interest rates work in your favor. CMBS loans, always with prepayment or prepayment clauses, are prohibitively expensive when prevailing interest rates are significantly lower than the note interest rate. As rates rise, these prepayment penalties are significantly reduced.
I recently updated a prepayment penalty calculation that was over $900,000 before the rate increase. Today it is closer to $350,000. While still significant, it is now in a range where it is practical to prepay existing debt and pull in significant equity by refinancing the property. In cases where a swap instrument is in place (to make a floating rate loan fixed through a counterparty agreement), many owners may be able to repay existing loans with a premium, which means that they will owe less than their current outstanding amount. balance.
Funding always makes sense
Another reason to consider financing now is to enjoy strong operating results. Many self-storage owners have seen year-over-year NOI increases of 10% to 20%. If this is your case, you are in an enviable position to consider refinancing and access a significant return on equity on your investments.
The low interest rates achieved over the past two years were an aberration and unsustainable. Current rates are well within the usual standard. To determine the prices of new loans, lenders must continually manage their respective lending platforms taking into account the specific availability and cost of funds and asset allocation. What is happening in today’s market is greater than usual differentiation between lenders in terms of terms, amounts and comparative loan rates.
Relationships with current lenders have value, business purpose and benefits. When it’s time to shop the market, it pays to hire an expert loan broker who can provide advice and information. Just because rates are rising doesn’t necessarily mean self-storage financing shouldn’t be considered. You just need to plan accordingly.
Neal Gussis is a director of a mortgage company CCM Commercial Mortgage. With over 30 years of experience as a national self-storage mortgage broker and advisor, he specializes in securing debt and equity for self-storage owners nationwide. He can be reached at 847.922.3750 Where [email protected].