hether we like it or not, we are all participants in the Federal Reserve’s efforts to tame inflation by aggressively increasing the Fed Funds Rate. Starting in March 2022, with inflation hitting double-digits, the Fed began its path of steadily instituting rate increases to the Federal Funds Rate. Historically, the Fed uses the Fed Funds Rate as a mechanism to either stimulate the economy or slow down the economy while trying to keep inflation at bay near a target of 2 percent annually. In March 2022, the Fed Funds rate was 0.25 percent to 0.50 percent—near all-time lows. Since then, they have had 11 rate bumps, resulting in the Fed Fund Rate, as of mid-August, now hitting 5.25 to 5.50 percent—the highest level since January 2001. Well, it is clear they have succeeded in reducing inflation significantly, and time will tell if they feel the need to implement additional rate hikes in the coming months. The results of these hikes are far-reaching, beyond just causing mortgage rates to rise. The accelerated pace of increases has given many capital providers new challenges well beyond just charging higher rates to their models of placing debt and equity.

(See Figure A)

FIGURE A

The rise in the Fed fund rates has a direct effect on the cost of capital across the board. All indices have risen significantly, having varied financial impact on owners. Those who are locked into fixed rates need to focus on the timing of maturities, while those who have mortgages that float are seeing their cash flow and expected returns deteriorate. The rise in short-term indices such as Prime, 30-day SOFR, or 30-day BSBY has hit hard for those that have variable rate loans, particularly those still in variable rate construction loans and highly leveraged SBA loans. In these instances, owners are now paying interest rates 5 percent or more than they were back in early 2022. Interest and operating shortfall reserves that were calculated based on even conservative assumptions are being drained quickly, and many are now having to infuse more cash during construction and lease-up. Owners seeking fixed-rate loans today should expect to pay interest rates elevated by 2 percent or higher than what would have been offered prior to the Federal Reserve’s actions.

(See Figure B)

FIGURE B

The severe increase in rates in a short period of time has put tremendous pressure on the capital markets. The closure of Signature Bank, Silicon Valley Bank, and First Republic banks sent warning shots to the industry for the need to manage risk, considering all new market conditions highly influenced and created by the Fed’s actions. There are substantial risk concerns that lenders must weigh today given the rapid rise in interest rates. They need to insulate themselves from being vulnerable to mark-to-market valuations of their portfolio and asset allocations by managing credit risk on existing real estate loans and consumer loans, managing deposits, and staying in regulatory compliance, just to name a few.

In terms of commercial real estate types, self-storage is among the preferred commercial properties to lend on with its reputation as a stable, recession-resistant asset class. However, it is a much tougher market to secure financing today, even for preferred property types. In response to our efforts in securing loan quotes and terms on our recent loan placements, we are seeing that many lenders are simply on the sideline or looking to make selective loans.

We are being told various reasons that a lender cannot quote on a loan request. Many are simply not making any new loans and managing their current loans. Others say they are only lending to existing customers. When seeking a loan for a regional or national self-storage operator, it is a common theme to get responses that the borrowers must reside in their footprint. Also, with an emphasis on deposits, in some cases, lenders require an expanded depository account beyond the operating account.

All commercial real estate is now being valued based on higher cap rates, resulting in lower values at a given net income. Transactional volume is down significantly across all commercial real estate sectors. The uncertainty of how high interest rates will increase and the ultimate effect on valuations have kept many buyers on the sideline. At the same time, unsustainable growth of revenues during the pandemic has leveled off to more historic levels, so most owners have less motivation to sell based on what buyers are willing to offer in this market.

Even with fewer buyers in the market, there still seems to be more demand than supply for acquisitions; thus, although cap rates have risen, they have not risen at the same pace as the cost of capital. Therefore, for those seeking to buy properties in this market, they may be faced with negative leverage, meaning the cost of capital is likely to be higher than the cap rate on which they are basing the purchase. The second effect of cap rates not staying linear with the cost of capital is that the loan-to-value will be lower, so buyers in this market are likely going to be required to put 40 to 50 percent down in equity. Lenders are being limited to Debt Service Requirements (DSC) where they are looking at Net Operating Income (NOI) to be somewhere more than 1.20 times the annual debt payment (principal and interest). This calculation is limiting the loan dollars and causing the lower LTVs.

Self-storage investors also need to pay close attention to managing all aspects of their loans that may be affected by the increase in rates. Loan covenants can be triggered for a variety of reasons, resulting from higher debt payments, lowering of values, liquidity requirements, etc. Be proactive with your lender in working through where the covenants may not be met. The regulators are providing guidance to the banks that allow some flexibility based on the sponsorship’s ability to pay and stay current. Please consult with your trusted advisors, legal and accounting professionals, if you are facing covenant and non-monetary or monetary defaults.

It is predicted that the Fed Fund Rates will peak in late 2023 or early 2024 and that there will be some downward movement in 2024, giving relief to those paying interest on variable-rate debt. Note that both the five- and 10-year Treasury yields are predicted to move slightly but stay above 4 percent. If predictions are correct, fixed-rate debt will not be going back down to the historic lows but is likely to be more in line with rates that we are experiencing today, maybe slightly less.

A good majority of owners took advantage of historically low rates and are now locked in and have some time before their loans either mature or reset. Please refer to Figure C. As with stocks, the rise in rates and decline in values are mainly relevant if you are financing or selling currently. Otherwise, you need to start looking to the future and planning for upcoming loan maturities. You should be calculating what loan amount your property will likely support based on forward-looking interest rate assumptions. There may be individual situations whereby a new loan will not provide proceeds enough to pay off existing debt.

(See Figure C)

FIGURE C

The Fed is well on its way to curbing inflation while it is still uncertain if there is going to be a soft landing or recession. There may also be a lingering tightening of credit and availability of capital.

The default rate on maturing loans is likely to rise, mostly from other commercial real estate sectors, particularly in the office sector, as borrowers are unable to seek replacement debt suitable to pay off current loans. The heightened risk awareness from capital providers will likely lead to an uneven playing field where stronger borrowers and properties have access to capital while weaker properties and weaker borrowers will have fewer alternatives.

Market conditions will once again evolve as some certainty of capital costs settle in once the Fed indicates that they no longer see a need to implement additional increases to the Fed Fund rates.

None of us can predict the future, so you should be thinking about how these higher interest rates may influence your investments and how to best position yourself in the coming years. Looking ahead, we are likely to see less construction, more consolidation, and an increase in transactional volume—all ultimately greatly influenced by the Federal Reserve and its control over the Federal Funds Rate.