Interest rates are up – way up. It’s the highest level in 20 years and still has not peaked. What will be the impact of these suddenly higher rates on the self-storage industry and what can you do to protect yourself and your investments in this unprecedented environment? In this episode, we’re going to cover the history of interest rates, how they affect every level of the storage business, what you can do to mitigate these issues and even some predictions for the future.
Episode 64: The Impact of Higher Interest Rates Transcript
Jerome Powell of the Federal Reserve has literally doubled interest rates in the year of 2022. What is the impact of that on the self-storage industry? This is Frank Rolfe with the Self-Storage University Podcast. We're gonna be talking about the impact on storage from higher rates. Well, let's start off with valuations, that's the first thing that should come to mind. We all know that when interest rates go up that means cap rates therefore go up. So, you can't get around the fact that higher rates are going to lead to lower values on self-storage facilities. There's no other way you can spin it. If a self-storage facility was worth X back if the cap rate was at 4%, and now the cap rate is at 8% is worth half of X. So yes, there will be some very large losses from people who bought storage facilities at those low cap rates that have occurred in recent times.
It's one time in which you... Probably half of you didn't buy a storage facility rather than you did, because you have to worry about the ramification of the interest rates on values. Now, there's one wild card to that is, will these interest rates stay where they are? Most economists are predicting they will not. In fact, a recent survey of some of the top economist think the rates will start declining in roughly May of 2023. Why would that be? Well, you see, the Fed only has one tool and that is interest rates. They raise interest rates to fend off inflation, but yet they lower them to restart the economy in the form of a recession.
So it's very likely that the Fed will have to reverse course even though they've raised the rates over three complete points this year and start dropping them back down to levels they were at before just the economy to get it restarted. Now, we were in a recession, we had two quarters of negative GDP, then we had a quarter of nearly flat but slightly positive, so that undefined the recession label, but everyone is predicting a recession next year. In fact, a recent article said that 100% of all US economists predict a recession in 2023. So you probably have to only survive this higher rate environment, oh, for probably another six months or so, at which time the Fed will start announcing the series of declining rates. But until that time, yes, if you bought something and the interest rates have doubled, then there's no question that probably what you bought is worth less than what you pay for it originally.
That is the danger, the damage of leverage. And that's what happens when you buy and sell properties based on income. Now, I would still rather buy income properties than something that has no income, where values are just based on some kind of erratic market that none of us can really quantify, but that is a danger. So yes, interest rates up means valuation's down. The only question is how long will those rates stay up? When will they start declining? Then you have the impact on banking, typically, when you have times of instability, which are brought on by things like crazy higher interest rates, banks do what's called a flight to quality. Now what does that mean? Well, a flight to quality means you look at loans from a new perspective. They say, "You know what? The loans are the safest, the ones where to less likely to default are the nicer ones, the nicer properties and nicer locations."
The problem is, if that's not the type of thing you're looking to buy in with your storage facility, that could be an issue. You may not be able to get a loan, or worse yet, you get a loan on the front-end, then when it comes up for a renewal, you can't get a replacement. Now how do you get around that? A good way to get around banking in times like we're in right now is through seller financing. And the good news is, a lot of the suburban and exurban self-storage facilities, seller financing is still attainable. If you have seller financing, you can not only get a lower rate than you can at a bank, but you get a non-recourse fixed rate longer term loan than you may from a bank. So that's one good way to mitigate and protect yourself in higher interest rate environments, is simply by sidestepping banking altogether and going with seller financing.
Next issue you're gonna have with higher rates, maybe some degree of issues with occupancy. The question now will be are people, when they have higher interest rates and higher mortgage rates and higher car payments and higher everything, America has been suffering through 10% inflation in recent times, which is the highest it's been in 40 years, will consumers stop using storage? Will they suddenly say, "You know what? We're not gonna store things anymore. We're gonna sell it all on eBay and shut it down and not pay that monthly amount." And yes, there are some customers who will. The key there is you've got to have properties that don't suffer from a massive amount of competition, properties where people are not marginal in their ability to make that regular average in the US, $150 a month rent payment.
Now where do you find that? Well again, all points of the compass show you need to be looking in more suburban and exurban markets, that's where the population is going, and that's particularly where the wealthier population is going. If you look at what's going on in America right now, people are leaving urban centers in droves thanks first to COVID and then the urban rioting, they're in search of a better, higher quality of life. They wanna go to a place where they have better schools and lower crime and less density and a nicer yard that they can go out and hang out in. And where do they get that? Well, they don't get it in the urban core. No, they're gonna get that by getting in their car and driving a little farther out and commuting to work a little farther. And even though I know gas prices are up, you can still lay it out, and if you take the gas price differential based on the home they can buy by driving a little farther out, they're still way ahead through suburban-exurban living.
So in those markets, I think you will be fine probably. But in those urban markets, oh heck, I can't even begin to guess where that will go. Also remember that most of these job layoffs people were talking about are technology jobs. And those technology folks are the ones who like living in that urban core. So when you face the fact that many of those people may end up unemployed suddenly and are riddled with all kinds of increases from inflation in almost everything they do, it's easy to see why those may be in more jeopardy. And the other is supply and demand, in the urban core, you have so many storage facilities all chasing after the same customers that when the market gets weaker and occupancy begins to diminish, they're all fighting each other to try and get those customers offering one month free and two month free and three month free, lower rates, things like that. That's a very, very tough market to do well in.
The bottom line to it all is that interest rates are and will always have an impact on self-storage investing. But it doesn't mean you can't buy something or that you can't do well at something even though the rates are higher. You have to just simply factor that into what you're doing. If you would all link it all together, what it would tell me is you want to be looking for storage facilities in suburban and exurban markets, areas where there's not as much competition yet there's higher discretionary income and you want to buy those at a price that allows you to get a reasonable modern loan and still have a good spread between the interest rate on that loan and the cap rate and what you're paying for the deal.
Remember, that the big tool to making high rates of return in storage and all income property investing is that spread between interest rate and cap rate. Since most investors are out there trying to get a double digit rate of return, it's impossible to do so unless you have a healthy, positive spread between the cap rate and the interest rate. If you were to buy something all cash at a cap rate of 7%, what would you have? A 7% return. But if I lever that at 70 or 80% loan-to-value at a interest rate, that's a point or more lower of what happens to me then, now I'm within shooting distance of hitting a 10% return, not because of performance of the property, but simply the addition of that lever of that tool.
So don't worry, don't fret about higher interest rates. Instead, take action, understand the environment, understand what the risks are. Understand how best to mediate those and mitigate those and you should be fine continuing to invest on despite the fact that Powell has raised the rates up so high. The other good news is, even as you enter a recession next year, which is in all likelihood what will occur, recessions have done well for the storage industry in the past. Many people in times of economic instability tend to store their things for security, they come and get them later when things are going better. So I don't think you're going to see widespread additional vacancy as a part of the recession, but the recession will usher in one important thing, and that will be a reduction in those interest rates. This is Frank Rolfe of the Self-Storage University Podcast, hope you enjoyed this. Talk to you again soon.