Interest Rates, The Stock Market and Self Storage Investments

By Michael L. McCune

By now everyone knows the Y2K bug didn’t stop the world’s financial markets, the FED didn’t raise rates in December ( but, probably will in February ), the stock market is spooked by higher long term bond rates and that "dot.com" investments aren’t bullet proof.  But what we are not so sure of is what impact all of this has on our investment in self-storage.  While we certainly do not have all the answers, by taking a look at some of these events in detail we can develop some perspective and prime our vision for future signs as this economy unfolds.

Rising interest rates clearly have a negative impact on the value of all income producing assets, it is just simple math – the more the lender gets, the less there is for the owner.  Despite the predictions last year that rates would go back down to their lows we have seen a steady climb in the long-term Treasury Bond rates. The absolute low was about 4.22% and many deals were done when the bonds were in the 5.00% range, and as I write this the Treasurys are trading at 6.57%. Apparently, in addition to the FED’s moves, investors are beginning to think there may be some new inflation coming. To get the interest rate that would be applicable for a 25 year self-storage mortgage you would add about 2.5% to the then current Treasury rate – or slightly more than 9% today. The add on, called a spread in the business, is to recognize that a self-storage loan is riskier than government bonds.

Let’s take a look at an example to see how the math really does work for someone purchasing a self-storage facility. Lets begin by assuming that a property generates a Net Operating Income (NOI) of $200,000 and that a lender is willing to make a 1.4 million dollar loan on the property. Assume also that an investor is thinking about buying the property on 10.5 Capitaliztion Rate for a price of about $1.9 million.  Lets now take a look at what the purchaser’s return on equity is assuming an interest rate of 7.5% and 9.1%.  Remember also that the payments include some amortization as well as just the interest.

As this example points out the rise in interest rates can impact a potential investor in at least three possible ways.  First, the investor will be a much less enthusiastic purchaser with a return that is dramatically reduced; secondly, the investor may perceive more risk in the transaction; and lastly he may be inclined to want a price reduction to increase his return. Obviously, none of the potential buyer’s reactions to interest rates are helpful to the potential seller’s value.  The net result is that if interest rates continue to remain high or to climb further there will be a negative impact on the value of self-storage facilities and will tend to materially increase Cap Rates.

On the other hand there may be some potential benefit from all of the recent gyrations in the stock market.  While the impact of rising interest rates on asset values is fact, all of what follows may just be gross speculation and we will likely just have to "hide and watch" to see what really happens. However, let’s have some peering into the future and see what might happen.

With the pressure on the high flying tech stocks there may be some renewed interest in the high dividends paid by the REITs.  This might allow the REITs to get back into the market and buy some additional units. However, even if this does happen, the interest rates will continue to impact the pricing of facilities.  While having the REITs buying again would be helpful, they would continue to be very selective and price ( i.e. return on equity ) conscious. Likewise, other investors may also tire of the volatility of the stock market and come back to real estate and self-storage.

people are still learning to use our product – only about 5 or 6% of the population has ever used self-storage! Thus, unlike apartments or offices, we don’t need live bodies to populate our product--- just more junk!  If just one percent more of the population learns about and uses self-storage our potential market grows by 20%--no other kind of real estate can make that claim. Having an investment community  knowledgeable about the potential of our industry will raise our values and liquidity.

For a more detailed review of valuation, cap rates and financial terms, we have articles available, both on the ARGUS Web Site, selfstorage.com and on our Fax Back Service FAX FACTS FAST at the toll free number 877-66-ARGUS.