he economic measures taken by the federal government during the pandemic have had sweeping consequences, and commercial real estate has been particularly hard hit by the fallout. The favorable self-storage lending climate enjoyed by buyers and developers just a few years ago is experiencing turbulence, with the cost of capital reaching its highest in over two decades. Current owners and would-be buyers who are caught in the fray may have to choose between some less-than-ideal options.
“The economy got overheated after COVID,” Neil Gussis, principal of Skokie, Ill.-based CCM Commercial Mortgage, says. “There was a lot of money pushed into the system and people wanted to spend it.” The robust spending led to inflation, and historically, the way to battle inflation is to raise interest rates to cool down the economy. The Federal Reserve began adjusting the federal funds target rate range steadily in 2022, raising the fed funds rate by more than five percentage points in just 16 months.
“Consequently,” Gussis says, “we’re at a historic high point in interest rates for the past 22 years, and we got there in a short amount of time.” Although viable deals are still out there due to the overall stability of self-storage as an investment type, the higher cost of capital is demanding that both buyers and sellers revise their expectations.
“To illustrate, consider 10-year CMBS loans executed in 2013 or 2014, which carried an average rate of 4 percent,” Snyder says. “Presently, newly available 10-year fixed-rate loans are priced within the range of 6.5 percent to 7 percent. The looming challenge stems from more than $200 billion in fixed-rate CMBS debt set to mature over the next 18 months, potentially complicating property owners’ refinancing efforts without substantial paydown requirements.”
Synder says this issue is compounded by the rapid escalation of short-term rates, with a base SOFR (Secured Overnight Financing Rate) surging from nearly 0 percent to over 5 percent within an unprecedented timeframe. “Consequently, a bridge loan established with a bank just 18 months ago at an interest rate around 3 percent could conceivably exceed 8 percent today,” he says.
R. Christian Sonne, executive vice president of self-storage for Irvine, Calif.-based Newmark, says small operators caught in the wrong position in this path have been hit particularly hard. “Even if your self-storage facility is doing great, if you had a 5 percent loan and now you have to refinance because it’s been 10 years and it’s due, it’s now 7.5 percent,” he says. “You were making $100,000 a year, and now you’re making $60,000. Your cash flow just gets crushed.”
Sonne says that mom-and-pop operators in that situation may be forced to sell. “There’s total sticker shock for people,” he says. “Banks get really tough on their underwriting, and they might tell you that you need to put another $100,000 into it. A small operator doesn’t have that laying around.”
Gussis says timing determines the position operators are in now. “The owners who opened up at the beginning of COVID won the lottery,” he says. “They leased up in 12 months when they thought they were going to lease up in 36 months.” However, for the same developer who started a project 18 months later, the economics are a totally different story.
Gussis notes that those who were caught during construction are most vulnerable. “If you have a variable rate construction loan where you were paying 4 percent, and now you’re paying 9.5 percent, that’s going to have a dramatic effect,” he says. Owners in this predicament will either have to put in more cash or sell.
“You put three or four years of your life into finding and getting the land, getting it permitted, getting all of the entitlements, and then doing it, and oftentimes, there is a psychological attachment to that deal,” Gussis says. “So, those owners have to decide how much time they want to give a project. Do you want to cut your losses now and limit your gains, or do you want to play the long game?”
“If you’re in the middle of development, each of those deals have to be reassessed both at the ownership level and the bank level, because they aren’t what they were penciled out to be,” Gussis says.
He says the transaction volume for the first six months this year was down about 70 percent from the same period last year. “The valuations went down when the interest rates went up, so the seller has these expectations from last year and the buyer can’t afford to pay that price,” Sonne says. “But people are adjusting and getting more realistic about their asking price.”
Shawn Hill, principal at Chicago-based The BSC Group, LLC, says that ample liquidity still exists in the market despite high interest rates and a general tightening in the banking community. “Capital is still flowing from banks, credit unions, life companies, CMBS, debt funds, and the SBA,” he says. However, lenders remain leery due to ambiguous language from the Fed regarding future rate hikes.
Hill says banks presently account for approximately 40 percent of all outstanding commercial real estate debt. “They are facing increasing regulatory pressure and have seen many of their existing loans not being paid off due to the lack of refinance opportunities,” he says. This has ballooned their balance sheets and has curtailed the capital they have available for new loans.
CMBS lenders are active, however, Snyder says owners are hesitant to commit to fixed-rate loans at rates exceeding 6 percent for 10 years. Consequently, although CMBS debt is accessible, it may not be the most attractive option in today’s climate. He says credit unions and insurance are other potential sources of capital, although they are more selective lenders.
“Life company allocations are getting full as we approach year end,” Hill says, “but self-storage remains attractive to many on larger, trophy-type deals in core markets.” He says there is still capital in the market for construction, bridge, and permanent executions. “We are definitely in a market where borrowers need to talk to a lot of lenders to ensure they are getting the best rates and terms possible, and we are definitely in a market where mortgage brokers can add a lot of value through their relationships and experience in structuring deals.”
According to Snyder, alternative lenders, such as debt funds, investment firms, and private money entities, are gearing up by expanding their workforces and preparing to fund substantial capital to address the gaps left by banks, insurance companies, and CMBS lenders. “However, they are capitalizing on the current market dynamics, offering interest rates at 8.5 percent and above,” he says. “While these rates may deter many, those in need of capital with projects capable of absorbing these rates—even if only for a brief duration—will find ample funding opportunities.”
Although Sonne says larger operators can have lines of credit up to as much as $100 million, he notes that when the cost of credit goes up, what they can afford to pay for a facility is less. “So, everybody’s unhappy,” he says. “You’re getting less money only because of the cost of interest rates and because banks are kind of sitting on their hands. The banks aren’t sure what’s going to happen in the economy, so they’re making it very difficult on people.”
For buyers, Gussis says new construction that’s 30 percent leased can be attractive. “They’ve already saved themselves three years of buying the land, getting it titled, and building it, so the question becomes, what’s the money value of time and what would it cost me to build it today?” If the buyer believes in the market, he says they’ll be willing to pay.
“Some owners are in so deep they can’t see the light of day,” Gussis says. “That portion of our sector is going to play out over the next six to 18 months. They have the toughest choices to make. I think we’re going to see more lease-up deals come to market.”
An upside for owners, he says, is that with new builds way down, they won’t be vulnerable to much new supply in 2025 and 2026.
“We haven’t seen anything like this since the late 70s, early 80s,” Sonne says, “but it was much, much worse then.” For context, the prime rate in mid-1984 was 13 percent, compared to 8.5 percent in mid-2023. We’re much better off now than 40 years ago. However, in March of 2020, it fell to 3.25 percent. “We were a little spoiled for a while,” Sonne says. “People got used to these 4 percent and 5 percent interest rates, but that was just abnormal. We’re really in an adjustment period now.”
Hill doesn’t believe we will go back to the extremely low rate environment we were in any time soon, if ever. “I think rates in the fives and sixes will persist for the next decade once things settle down,” he says.
As for operations, consumer demand hasn’t shifted much, according to Gussis, although it’s uneven across markets. “If you look at the Almanac, no matter what cycle we’re in, national levels of occupancy have never varied more than 5 percent year-to-year,” he says. “Operations are still going great.”
Sonne believes it’s a great time to buy self-storage as long as you recognize that you won’t get the same return as in recent years. “There’s more capital that wants to invest in self-storage than there is storage available because of the stability of the industry,” he says. “It continues to perform well, even in uncertain times like we have now.”