he record-low interest rate and easy-money environment the self-storage industry enjoyed from mid-2020 through mid-2022 sadly came to an abrupt end in 2023 as interest rates skyrocketed and credit markets tightened up. What does 2024 have in store for self-storage owners seeking financing for a new construction project, the acquisition of a new property, or simply the refinance of an existing facility?

In the first quarter of 2024, the cost of debt is substantially higher than it was only a short time ago, and many commercial real estate lenders have become more selective, more conservative, more expensive, or have stopped lending for the time being.

The good news, however, is that self-storage is still considered by most lenders to be a very desirable asset class in comparison to most other commercial real estate types. More good news was revealed in mid-December when the central bank signaled that its inflation-fighting strategy of raising rates was likely done and that multiple rate cuts were on the table for 2024. U.S. Treasury rates have begun to ease but are still a long way off from the lows of the prior few years. Despite these positives, self-storage borrowers will very likely continue to face some financing challenges into 2024 and beyond.

Just a short time after the COVID pandemic began in 2020, interest rates dropped to record lows as the Federal Reserve quickly eased monetary policy by cutting the fed funds rate to almost zero, and lenders were as hungry as ever to make self-storage loans. Record-breaking self-storage industry operating performance and NOI growth from mid-2020 through most of 2022 further whetted lender appetite for self-storage loans over other commercial property types, and interest rates for loans on new construction projects as well as stabilized properties were mostly in the 3 percent to 4 percent range as lenders competed for self-storage financing opportunities.

However, as with most good things, the most favorable self-storage financing environment on record finally deteriorated towards the end of 2022 and continued throughout 2023. In the battle to curb post-pandemic inflation, the Federal Reserve quickly reversed course and increased the fed funds rate at a breakneck pace (11 times from March 2022 through July 2023) to the highest level in 22 years, causing borrowing costs to quickly skyrocket and causing major stress in the banking industry. Although the banking industry did not collapse as it had during the Great Recession of 2008, a small number of banks failed as a direct result of fed policy and many other banks quickly pulled back from commercial real estate lending to varying degrees or stopped lending altogether.

As the fed funds rate quickly increased, other short-term rates followed in an almost lock-step fashion. Prime Rate increased from 3.50 percent to 8.50 percent and 30-day SOFR increased from 0.05 percent to 5.00 percent. Loan payments for adjustable-rate loans more than doubled for many borrowers, prematurely depleting interest reserves and requiring additional borrower cash infusions for many construction and value-add projects. While existing fixed-rate borrowers did not suffer the same fate, interest rates for new fixed-rate loans more than doubled from the 3 percent to 4 percent range to the 7 percent to 9 percent range as the five-year and 10-year U.S. Treasury rates climbed over 400 basis points from mid-2020 lows to almost 5.00 percent by October of 2023.

In addition to increasing base index rates, lender spreads also increased. Spreads are the amounts lenders add to the index rate to determine the total interest rate and can be affected by a lender’s cost of funds, target profit margins, perceived loan risk, current lending allocations, and lender market competition.

While self-storage financing is provided by credit unions, life insurance companies, CMBS lenders, SBA lenders, private debt funds, and others, banks have historically provided most of the lending to the self-storage industry. Banks currently hold over 50 percent of all commercial real estate outstanding debt, which today stands at just under $6 trillion, according to Trepp and the Federal Reserve.

Because of the stress created primarily by the quick and drastic run-up in short-term interest rates, many banks do not have the appetite or capacity to make new commercial real estate loans. Compounding the issue is the fact that payoffs of existing loans on the balance sheet have slowed, further hindering banks from recycling their outstanding capital into new loans. For the banks who are still actively lending today, many have limited allocations for new loans and typically reserve that capacity for their existing customers or new customers who can bring deposits to the bank.

For these reasons and more, 2024 may be the year that non-bank lenders, including CMBS lenders, life insurance companies, debt funds, and others, pick up some of the slack from the banking sector. The lending capacity of these non-bank lenders has not been affected nearly to the same extent as the banking sector.

No matter the type of lender, self-storage loans will be generally more difficult to underwrite in 2024, and loan proceeds will be more constrained in today’s higher rate environment. In a low interest rate environment, loan proceeds for existing facilities are mostly limited by a maximum loan-to-value (LTV) in the 75 percent range. As interest rates have increased, loan proceeds have become constrained less by LTV and more so by the debt service coverage ratio (DSCR), which is the key measure of a property’s cashflow ability to cover the new loan payment. In today’s higher interest rate environment, a minimum 1.25x DSCR underwriting metric often results in maximum loan proceeds equating to just 50 percent to 65 percent LTV, thereby requiring buyers to come to closing with 35 percent to 50 percent for a new purchase. For borrowers refinancing their property, a minimum DSCR requirement of 1.25x may limit new loan proceeds to an amount that is less than their outstanding loan balance, especially in cases where the existing loan was high-leverage and/or NOI has not materially increased.

NOI underwriting has also become more challenging as the self-storage industry operating performance has cooled off over the last year or so. Nationally, self-storage occupancies and “street” rental rates (rates charged to new customers) have begun to drop from their pandemic-fueled highs, resulting in challenges to continued revenue and NOI growth. While increasingly sophisticated revenue management tools have preserved or even grown existing customer rental income (ECRI), ever-increasing insurance premiums, real estate taxes, and payroll expenses present further challenges to NOI growth. In addition to higher interest rates, these income and expense trends could very well further limit loan proceeds for an existing property. Underwriting for new construction projects shares all of these challenges and is also hampered by increased interest carry, slower lease-up projections, and lower rental growth projections.

In light of the headwinds facing the self-storage financing landscape in the coming year, here are some important factors to keep in mind when heading out into the financing marketplace:

• Keep perspective that today’s lending environment is not unlike others that we have experienced in prior economic cycles; there is still plenty of capital out there for our industry, albeit at lower leverage and higher rates than in the recent past.
• While there is a glimmer of hope that interest rates will back off a bit from recent highs, interest rates in the 3 percent to 4 percent range were a short-lived “blip” and are extremely unlikely to return without a major financial crisis or detrimental U.S. domestic or global event.
• Carefully evaluate new construction and acquisition opportunities, incorporating assumptions that include today’s interest rates are likely here for a while, self-storage rental growth has slowed or reversed in many markets, and operating expenses such as insurance, property taxes, and payroll will likely continue to increase.
• Educate yourself to better understand how lenders will underwrite income and expenses for new a loan today, making sure that your loan request is realistic so lenders will take the time and interest to work with you on a financing solution.
• Most importantly, widely diversify your lending sources to include many lenders across the many different lending platforms. “Relationship” lending often dries up in trying times, and while one lender may have stopped lending today, there are many others still actively lending.