MONEY TALK

As of late Alan Greenspan has continued his assault on “inflation” and is expected to do so for the foreseeable future.  While we have reported in these pages in the past that rising interest rates would and have created a financing environment that is less desirable than the one 24 months ago, we thought we would call in for a second opinion. In this issue we take a minute to converse with Neal Gussis, a veteran of the self-storage lending business. He is a Senior Vice President at Beacon Realty Capital, Inc, a financial services firm that arranges debt and equity transactions for self-storage and other commercial real estate owners. Neal has the experience of funding over 250 self-storage transactions and works for his clients to obtain the optimal financing solution.  If you have any further questions, please feel free to call him at (312) 207-8240.

Argus: The Federal Reserve seems persistent in pushing up interest rates. How does this affect self-storage financing? How about construction financing?

Gussis: Every time that Mr. Greenspan and his committee have increased the overnight bank rate, banks have in turn increased their prime lending rates. Therefore, loans that are tied to the prime rate are experiencing increased interest rates. The current overnight bank rate of 6.5% is the highest it has been in 9 years resulting in prime rates of 9.5% at most banks.

With regard to permanent financing, interest rates offered by all lending sources are generally 1 to 2% higher than they were a year ago.  However, not all mortgages are based on the prime rate.  Many permanent mortgages are based on indices like the Treasury rate or LIBOR.  Over the short term, there can be a disconnection between these indices and Greenspan’s agenda of increasing rates.  For example between February and May, the Treasury rate decreased and then increased almost 1% and this volatility is likely to continue.  

Spreads (markup over the index rate) that are quoted by lending sources also are volatile and move almost on a weekly, sometimes daily basis. Therefore, if you are in the market to finance, depending on the index that your loan is based on and when you actually lock in your interest rate, I predict your rate could vary from 8.75% to 10.75%.

A majority of construction loans are provided by local banks, which use the prime rate as an index. Certainly, developers will need to reevaluate their position on a project based on economic feasibility at higher interest rates.

Argus: Do higher interest rates mean lower loan amounts?

Gussis: Sometimes an increase in interest rates causes loan dollars to decrease.  The next question is why only sometimes.  The answer is found by determining the “interest rate breaking point”. 

Let me explain.  Lenders generally need to satisfy two main underwriting requirement in determining your loan amount: Loan to Value (LTV) Ratio and Debt Service Coverage (DSC) Ratio.

Loan to Value – This simple formula is used to compare the loan amount to the value of the property.  Most lenders are lending up to 75% of the value.  This means that if you have a property valued at $2,000,000 the lender will allow you to borrow $1,500,000.

Debt Service Coverage  - Also a simple formula, this comparison takes your net operating income (NOI) and divides it by your monthly mortgage payments for the year.  In most circumstances lending sources are seeking a 1.30 DSC for self-storage properties.  For example, if you have a NOI of $200,000, you can have up to $153,846 of annual debt: $200,000/$153,846 = 1.30 DSC.

Since 1994 because low interest rates caused low debt payments, almost all loans were being based on the maximum LTV.  For example, the typical loan in the summer of 1999 was 8.25%.  A facility having a $200,000 NOI and a value of approximately $1,951,000 (based on a 10.25% Cap rate) could qualify for a 75% loan of approximately $1,463,000, although a 1.30 DSC could have supported a much higher loan of $1,625,000.

Argus: So the question is at what point do interest rates cause the DSC to become the limiting factor in lenders’ underwriting decisions? 

Gussis: The answer is the “current interest rate breaking point” is 9.5%. This is not a universal answer, but is supported by the following assumptions.  A loan is being made for a property being valued at a 10.25 Cap rate, and being financed over a 25-year amortization.

The effect of a shorter amortization period is quite dramatic in the calculation of the “interest rate breaking point”.  For example if amortization went from a 25 year period to a 20 year period, the interest rate could not rise above approximately 9% before you would experience a reduction in loan dollars based on DSC.

On the other hand, a favorable valuation might not help you in a higher interest rate environment.  For example if your property was valued at a 10% Cap rate, the “interest rate breaking point” is reduced to 9.2%.  Typical interest rates today range from 9.0% to 10.5%, therefore in many instances the loan dollars could be limited by the DSC minimum requirement.

Argus: How has the structure of financing changed based on today’s interest rate environment?

Gussis: The structures being offered by lenders are being designed based on the owners financing objectives.  There are variable rate and fixed rate mortgages being offered from a variety of capital sources.  The interest rates for variable rate and fixed rate loans generally calculate out to be within .5% of each other.  The owners also need to determine the length of the loan and the flexibility of loan terms that they are seeking.  Lenders are offering loans with terms ranging from 3 to 15 years.   Generally, the variable rate loans have significantly less prepayment provisions in comparison to the fixed rate loans.

There are also lending programs which allow you to float (variable rate) for up to 18 months and should you choose, you can lock your rate into a fixed rate. If you choose not to fix your rate, then the loan remains variable for the remaining term.  This feature may allow you to take advantage of the disconnection between short-term rate volatility of the underlying real estate asset credit risk.

Argus: Do you have any advice for our readers?

Gussis: There still are a variety of loan programs at rates that can maximize loan dollars, but rates will continue to change. Long-term objectives should be used to determine your short-term financial decisions. Even if interest rates are higher than they were a year ago, it still may be a wise move to consider financing alternatives.  We are now at a point at which, if interest rates do move further north, owners looking to acquire properties will need to reevaluate both the return on investment and their desire to fund increased down payments to cover the decrease in available leverage.