Interest rates have begun an expected steep climb this year as the Federal Reserve moves to get inflation under control.
Self storage developers could be among the first to feel the pinch with variable-rate construction loans moving during a robust period for construction. Buyers who rely on debt to make self storage investments will also see the cost of the transaction go up, which could influence the price they are willing to pay.
Along with the Fed’s move, lending markets are pricing in the risk of Russia’s war on Ukraine, making the lending environment far more unpredictable than it has been.
“It’s a very difficult time to project spreads or even interest rates on a loan closing 45 days from now, let alone where we will be a year and a half from now,” said Shawn Hill, a partner with The BSC Group, which provides debt and equity financing for self storage. “In the short term, we may experience some market dislocation because borrowers are going to be feeling pain in real time of rapidly rising rates, but sellers often take time to adjust their expectations.”
In mid-March, the Federal Reserve moved its funds rate up a quarter-percent after holding it at nearly zero for the past two years during the pandemic. March’s move was modest, but Chairman Jerome Powell (pictured) announced that the Fed is likely to move the rate six more times this year, far more than originally predicted.
The central bank’s rate is what banks charge when lending money to each other and is a proxy for the interest rates that consumers pay for mortgages and credit cards.
Just two weeks after the Fed’s action, Hill said the best terms for long-term, fixed-rate CMBS deals had jumped from interest rates in the 2.75% to 3% range to rates of 4% and 4.25%.
With the Fed signaling that it plans to create a rising interest rate climate, investors expect the cost of capital to go up, which could create a headwind for commercial real estate transaction activity.
Impact on Development
The number of self storage facilities under development has been rising over the past six months. According to Yardi data, there has been a 63% increase in the number of facilities at various stages of development from September 2021 to March 2022.
“There is a lot of storage development going on,” Hill said. “For developers in the middle of a project, their debt is mostly variable rate.”
David DiRienzo, director of business development for Talonvest Capital, said in a rising rate environment, borrowers can use tools such as interest rate caps or swap transactions as a hedge against interest rate risk on floating rate construction and bridge loans.
“Interest rate caps are like buying an insurance policy where the borrower pays a premium to protect them from rising rates,” DiRienzo said.
Impact on Buyers and Sellers’
Despite increasing risk in the market, Mike Mele, vice chairman of the self storage advisory group of Cushman & Wakefield, said properties continue to trade. And he expects a strong year of transactions to follow the record year in 2021.
“One of the benefits of so much equity out there is that it keeps driving prices,” Mele said. “Properties will still trade. Our pipeline for this year is still extremely full and should equal last year.”
A portion of strong sales in 2021 was due to concern that the Biden administration would raise the capital gains tax. That concern – which did not materialize – drove many sellers to cash out while capital gains are relatively low. Mele said rising interest rates could have the same effect of accelerating transactions.
“The amount of private clients who sold last year was big, and now we’ve got another dilemma,” Mele said. “We definitely have people who want to sell now, because higher rates will mean lower prices.”
As rates rise this year, it is possible that buyers and sellers will have a harder time agreeing on a sales price.
“Buyers and borrowers are dealing with the real-time cost of financing, but sellers will not yet have adjusted their expectations,” Hill said. “What people will pay for an asset starts shrinking so that would tell you the sooner you transact the better.”
DiRienzo said the strong operating fundamentals of self storage will continue to attract buyers.
“We believe investors will continue targeting high quality assets in markets with strong underlying fundamentals and positive demographic trends,” he said.
Impact on Cap Rates
Despite movement on lending terms, John Chang, Marcus & Millichap’s senior vice president director of research services, said in a video addressing the Fed’s actions that he did not expect cap rates to be negatively impacted, at least not immediately.
Cap rates for the most sought-after property types in the best markets are in the mid-2% range. Even as interest rates go up, Chang thinks strong buy-side sentiment and the flood of capital entering commercial real estate offsets the headwind.
“It doesn’t look like cap rates will push higher,” he said of the immediate future. Eventually, higher rates will cool activity.
In Marcus & Millichap’s most recent survey of investors, 63% of respondents said they would buy less commercial real estate if rates hit 3.9%, a rate likely to be reached on the Fed’s stated trajectory.
“If you want to buy, get active now before rates go up too much,” Chang said. “And if you plan to sell, get active now while there is a lot of active buyers.”