The longevity debate about today’s low interest rate environment reminds me of Goldilocks and the Three Bears: After holding the benchmark short-term interest rate near zero for the past six years, the Federal Reserve continually takes our nation’s economic temperature to ensure it is not too hot and not too cold, and then based upon the readings, could potentially make changes. While low interest rates motivate storage owners to refinance their properties and save on monthly payments, the other side of the equation is your comfort level with the property’s leverage. With rising real estate values and operating income, refinancing can replace your existing debt and increase loan amounts, but you have to find a loan program with just the right temperature for your leverage risk tolerance.
Impact Of Central Bank Decisions
In May, Fed Chairwoman Janet Yellen indicated the central bank is on track to raise interest rates this year, but proceeding cautiously because the job market hasn’t fully healed, inflation is low and economic growth remains slow nationwide. She said it could be several years before the benchmark short-term rate returns to a level considered to be “normal” for the long Lesson Learned Pursuing Not-Too-Hot/ Not-Too-Cold Leverage Strategies By Neal Gussis run. Many analysts believe an initial rate pop could occur as early as September 2015.
While any Fed rate increase will directly impact shorter-term variable rate loans based on Prime and other indices related to a bank’s cost of funds, the impact on longer-term indices—such as the five-, seven- or 10-year Treasury—is unknown. As this chart shows, the yield curve difference between short-term and 10-year rates ranges widely. Even if the Fed target rate increases this year, longer term loans could remain low for a while. See table below. Low interest rates also contribute to compressing capitalization (cap) rates on real estate property valuations, thus increasing them. It’s now common for storage properties to appraise between a 5 percent and 7 percent cap rate depending on size, quality and location. So given this macroenvironmental background, leveraging your property when you refinance entails evaluating four factors:
• Interest Rate
• Cash on Cash Returns
• Recourse Obligations
• Leverage Comfort Levels
Interest rates for conventional fixed rate loans on stabilized assets now range from 3.5 percent to 4.75 percent for a five-year term, and 4 percent to 4.75 percent for 10-year terms (offered primarily by CMBS lenders). As you decrease leverage, expect lenders to offer lower spreads. It’s not uncommon to reduce loan rate spreads by 25 basis points (one-quarter of 1 percent) or more when going from a 75 percent loan-to-value (LTV) ratio to a 50 percent LTV. For those seeking leverage higher than 75 percent to 80 percent LTV on stabilized assets, expect an approximate loan rate increase of 50 basis points, or one-half of one percent.
While options beyond 80 percent LTV leverage are limited, you do have choices. For example, Jernigan Capital offers financing up to 90 percent LTV at a 6.9 percent rate. Many lenders also scrutinize higher leverage transactions that provide a large amount of cash back to borrowers. Typically, larger loan sizes offer better available pricing options. Lenders see small loans taking as much time to complete as larger ones, and therefore price them higher to compensate for their effort.
Any Way Around Recourse?
Most storage properties financed by local or regional banks require full personal recourse. However their tolerance and acceptance of partial or non-recourse financing can depend upon leverage, such as partial recourse provisions of 25 percent to 75 percent for loans with 50 percent to 65 percent LTV. Some lenders offer fully non-recourse loans for properties with 50 percent LTV or less, while others have recourse that burns off based on LTV or debt service coverage targets.
For a non-recourse, high-leverage loan with the ability to pull equity (cash) from refinancing, then check out securitized CMBS alternatives. Many CMBS loans offer five- to 10-year fixed rates, up to 75 percent LTV on a non-recourse basis (with standard carve-out exceptions), 30-year amortization, and interestonly payments for the loan’s initial 24 to 36 months.
Not-Too-Hot, Not-Too-Cold Leverage
As this chart demonstrates, increased leverage not only offers a better cash-on cash return when the net operating income (NOI) percentage exceeds the interest rate, but also allows investors to diversify their portfolio holdings by spreading equity to more investments. See the Leveraged Return table below. Back to the Goldilocks analogy, my 20-plus years of brokering storage property financing has shown that owners prefer to maintain a not-too-hot/nottoo-cold LTV level of 65 percent to 75 percent. With higher leverage, the risk increases that the property can sustain the operating performance to cover debt and/or valuation decreases. If capital markets continue offering aggressive loan terms, expect more lenders to provide opportunities to increase leverage above traditional levels.
Keeping payments the same while reaping refinancing benefits is a popular investment philosophy for storage owners accustomed to certain cash flows after their current debt service. With many of today’s refinancing packages reducing interest rates by 2 percent or more, you can request a loan larger than your current balance and maintain existing monthly payments. Further, by increasing the amortization period by another five years (say from 25 to 30 years), the loan amount can rise even more without higher monthly payments.
Other owners will lock into a fixed rate CMBS deal for 10 years to achieve maximum leverage in case they cannot refinance again until maturity due to associated pre-payment penalties. CMBS lenders are most lenient when allowing borrowers to cash out based on the property’s historic operating performance and valuation. Owners following this approach will also encounter exposure to recourse based on the carve-out provisions. These loans are assumable and may be attractive to a future buyer should interest rates spike. More conservative storage owners—especially those focusing on retirement planning— may pursue fully amortized financing or loans with lower amortization that can be quickly paid down. By following this investment philosophy, they can likely sell the asset and receive plenty of equity for their retirement.
While the nation’s storage landscape is in great shape, markets pursue unpredictable cycles. Some of our industry’s best operators painfully learned their lessons with poor or untimely leverage decisions during the last financial downturn. If you can refinance today or in the near future, then capitalize on aggressive interest rates and lending alternatives, but be sure to fully understand your property leverage and its associated risks and liabilities. At the recent Self Storage Association Economic Summit, a leading CMBS lender commented, “Don’t let lenders determine how much you can borrow.” This observation truly reflects today’s not-too-hot/not-too-cold capital markets. Just like a good bowl of porridge, you don’t want to get burned when dipping into refinancing, but you don’t want to be left out in the cold either.