Inside Self-Storage

JAN 2019

Inside Self-Storage (ISS) is an information source for industry owners, managers, developers and investors covering news, trends, facility operation, finance, real estate, construction, development, marketing, technology, insurance and legality.

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S elf-storage financing is beginning to feel a little different these days. There's no denying the industry has enjoyed an outstanding run for several years, fueled by strong occupancies, year-over-year revenue increases, strong valuations and investor demand. There's also been plentiful availability of debt at low interest rates. The problem is some of these factors have started to plateau. Specifically, interest rates are now on the rise, and an increased supply of facilities has created rental-pricing pressure in some submarkets. This will have a direct impact on your ability to borrow money. Upward Pressure In a way, we've been lulled into a comfort zone during the past few years thanks to low interest rates and only incremental movement by the Federal Reserve when it's made policy changes. Further, the economy has been humming along with the lowest unemployment levels in nearly 50 years; the Dow Jones has bumped against new highs; and the federal government has provided fuel to extend the recovery from the 2008 financial crisis. But don't get too comfortable. These factors are really just precursors for interest rates returning to more normalized (i.e., historically higher) levels. As of early October, the Fed had raised the Federal Funds Target Rate (FFTR) three times in 2018, with an additional rate hike likely before year-end. Lenders base loan rates on a spread over various indices. The accompanying table highlights rate increases for several commonly used indices, including a recent 30-day period, year over year, and the past three years. Historically, the 30-day LIBOR and prime rate are highly correlated to FFTR movement. So, as the Fed continues with incremental bumps, you'll see these rates move accordingly. Short- and long-term Treasury yields are based on many factors and aren't linear relative to FFTR adjustments. Looking at the table you'll notice shorter-duration bond rates increase at a faster clip than longer-term bond options. Thus, we're inching closer to a flattening yield curve in which short-term loans will pay interest rates equal to, or even above, longer-term loans. Good News, Bad News It's always better to start with the good news. While rising indices mean loan rates are on the rise, a positive takeaway is spreads have remained neutral or slightly decreased. This has softened the increase in resulting mortgage interest rates. Further, stretching back to the fourth quarter of 2015, the Fed target rate, 30-day LIBOR and prime rate, which are typically used for variable-rate loans, have increased approximately 2 percent. At the same time, the longer-term 10-year Treasury yield, which is tied to fixed-rate financing, has inched up only about 1 percent. When factoring in spreads over the indices, many variable-rate loans tied to the prime rate and LIBOR that had lower overall interest rates compared to five- or 10-year fixed-rate loans are now actually higher and will continue to climb as the Fed further increases the target rate. Nearly all construction loans are variable-rate and will be affected by these changes. Now for the bad news. Higher interest rates cause debt-service payments to rise and put additional stress on debt-service coverage (DSC). This means the availability of maximum loan dollars decreases because minimum DSC is needed to meet the lender's requirement covenants. The minimum DSC constraint—usually between 1.2 percent and 1.3 percent (calculated by net operating income divided by debt payment)—may result in loan proceeds at a lower loan-to-value Interest-Rate Summary as of 10/3/2018 Fed Funds Target Rate 30-Day LIBOR Prime 1-Year Treasury Yield 5-Year Treasury Yield 10-Year Treasury Yield Current Rate 2.00% 2.40% 5.25% 2.62% 3.02% 3.15% Last Month Rate 1.75% 2.12% 5.00% 2.49% 2.76% 2.91% Rate Increase Past Month 0.25% 0.28% 0.25% 0.13% 0.26% 0.24% Last Year's Rate 1.00% 1.28% 4.25% 1.35% 1.94% 2.35% Rate Increase Last Year 1.00% 1.12% 1.00% 1.27% 1.08% 0.80% Rate 3 Years Ago 0.00% 0.19% 3.25% 0.27% 1.37% 2.12% Rate Increase 3 Years Ago 2.00% 2.21% 2.00% 2.35% 1.65% 1.03% Source: U.S. Census Bureau The impact of rising interest rates and new supply By Neal Gussis Cautionary Shifts in Self-Storage Financing 22 ISS I January 2019

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