The number one topic in the news is the return of inflation. It’s at the highest pace in nearly two decades, and that’s got serious ramifications in a number of areas. So how will the return of inflation impact self-storage investing? That’s the topic of this Self-Storage University podcast, and we’re going to explore all the pros and cons. It’s a very important issue and worthy of a lengthy discussion.
Episode 28: The Impact of Inflation on Self-Storage Investing Transcript
Inflation is coming back. Have you been thinking how it's going to impact Self Storage investing? This is Frank Rolfe, the Self Storage University Podcast. We're going to be talking about the impacts of inflation on the self storage industry.
Now, inflation is a scary thing, because in inflation, you have a continual rise in prices. And as a result, it makes the value of the dollar seemingly go down because the dollar can't buy as much product today as it bought yesterday. And I remember back in college, I was an economics major at Stanford University. And I remember well, because I was back in the era of inflation. I went to college back in the days of Jimmy Carter and all the inflation issues we had back then. And inflation was a big deal. And I remember in my class, the professor said there were only two things that did well in inflation. Number one, real estate, number two, gold, silver, precious metals.
Now, why is that? Why do they hold their value? Well, it's because you got to have real estate. And most people want to have precious metals. And so basically, people are going to pay whatever the market requires for those items. So if you have a house, you have high levels of inflation, and that house then goes up in value to 1,500,000, you want to own a house. You want to own something that's a hard asset. You don't want to be owning stocks don't want to be owning bonds, these things traditionally do not do well as the dollar loses value.
So where does self storage fit into that? Well, definitely, it would fit in under real estate, and even better it is income property. The problem with houses is that they're simply based on speculation. Rarely does the income of the house warrant the price that you pay. A lot of people pay that extra just to have the pride of ownership, because they want to own that house in that neighborhood. Self storage is a much more clean and pure transaction, because it is literally based just on income. And it's assumed that as prices rise with inflation, so would the amount that you can charge in rent. Your customers can't just pick up and throw one or two items in the back of their car. To move out of your self storage facility would require a lot of time and effort. And on top of that, what would be the point if all the others rents gone up as well. So I'm pretty comfortable that the self storage asset itself should do pretty well, in inflationary times.
However, there are other issues, despite just that one that need to be considered. First off, interest rates on bank debt typically correspond to rates of inflation. That's because investors don't like to go backwards. We've had very, very low to virtually no inflation for a long period of time. And during that time, we've had the lowest interest rates in American history. And it all worked because they were still higher than the rate of inflation, which was virtually zero. Now we're talking about inflation going up to three or four or even 5% a year. That's going to require people to want higher interest rates so they can stay ahead of inflation. As interest rates go up, what also goes up? Well, cap rates go up. And since all income property is defined as a measure based on a cap rate, as those cap rates increase the values of the assets decrease. So it all means to me is if we're going to go into a higher inflation moment, you've got to buy properties at cap rates that give you enough buffer to feel good about yourself if interest rates start to increase, and that have the ability to actually take the value and the income on that property up even higher, either through higher occupancy or higher rents.
So what it means to me when you go into inflation is you definitely need to be a smarter buyer. You can no longer buy any self storage property at a very low cap rate at a very small measure above your bank loan rate and feel good about it. Because I would think we would all have to agree the direction of interest rates and cap rates is probably up. Also, don't forget you're going to have a lot more difficulty getting loans at times when banks have problems. And banks are well known to have problems in inflationary times. I've been through one of those, the Texas S&L crash back in the 1980s. You couldn't get a loan during that period in Texas or Oklahoma if life depended on it. Most people needing bank lending had to retreat to other states. What if you had a national recession of that capability, you wouldn't have any state to go to right? Banking crises are tough. It's bad for everyone. It's bad for businesses who can't get loans. It's even bad for banks that require loans in order to make money.
There was a lot of bank foreclosures during the Texas S&L crash. Those banks were taken back by bureaucrats, by the FDIC. They didn't make any loans. They didn't even know how to make any loans. They weren't even bankers. So the key is, if we're going to go into inflation, I think you have to imagine there's a risk of some kind of banking instability. And that means it will be harder to get loans. So just be aware of that. There may be come a time when it'd be harder than ever to get a loan to buy a storage facility. So be nimble, be quick, try and do it right now, while the banking world is strong, because banks do not like unstable environments.
It also means if you have an existing loan or buying a storage facility right now, go for stuff that has a fixed interest rate. Variable rates only benefit the borrower when there's a possibility that rates might go down. There have been periods in American history where borrowers wanted variable rates, because they knew the rates would go down. Case in point under Ronald Reagan, interest rates on loans went all the way up to about 15-16%. Borrowers didn't want to be locked in at 15% or 16%, so everyone asked to have a variable rate loan, knowing those rates would, which they did, declined back down to around 6% or 7%. At times like these that were rates are the lowest in American history or close to the lowest, you can only guess I'll go only one direction and that direction is Up. So try and get fixed rates on your loans.
Also try and get the longest loan term you can. If you can get a 10 year loan, take it. If you can get a seven year loan, I would take that over a five year loan. If you get a five year loan, see if you can have the ability to buy an extension for a couple years if you need to. Some lenders, typically mom and pop seller carry, will allow you if you give extra money down towards the down payment, if you need it not in advance of that, that you can get an extension on your loan. Because we don't know where banking will be five, seven, or 10 years from now. But we know there's probably going to be some degree of instability somewhere along the line. Look at the stock market. It's the highest it has ever been in American history. It only has one really one direction to go.
Look at the valuations of some of the companies. Some of the highest valued companies have no income. Look at the values on such companies as Tesla. Now people would say, well, Tesla is a horrible speculative bubble. I don't know that for a fact. There have been other companies in the past with high valuations, who later stepped into their oversized shoes. But I've never seen a depth of stocks, even Warren Buffett has pointed this out. The measure the metrics of stocks right now are absolutely unhinged. As a result, when those stocks ultimately fail, in some degree, some of the must, there will be some ramifications for the banking industry. So right now with the potential of inflation going up, which typically also means inflation goes up stocks or bonds do terrible, I would want to make sure that I have the safest harbor I can on my debt - long, long loan terms. And if possible, fixed rates throughout.
Also, don't forget, it's critical when you're buying a property right now in an environment like this, you've got to make sure that you have plenty of fluff in what you're doing. Buy only things that have really, really good solid upside. I always think whenever you buy a property, you need to look at three scenarios: the best case, the realistic case, and the worst case. Now the worst case can't be an Armageddon worst case. If that were the true in life, nothing would work. If I said, Well, I can't drive my car if I can't handle the worst case, the worst case was I pull out of my driveway be hit by a bus and blow up, then I can't ever drive a car again. So we have to make some reasonable bets. But right now, the reasonable bets are that you're going to have higher inflation, higher interest rates, higher cap rates. And so you've got to buy properties that are built for that.
When I watch these large companies buying these self storage facilities at low cap rates with very little upside, even though I know they're seasoned operators and some of them are public REITs, you have to question the actual intelligence of what they're doing exactly. Some groups are only there to actually try and harvest greater fees known as AUMs or asset under management. So they're not looking perhaps as you would to try to actually make money with that thing. Their money comes just in the form of adding it to the portfolio. But for the typical small investor today, I would only want to focus on properties that I feel I can strongly increase occupancy, increase rents or cut costs, because you've got to do more than tread water. As you build the income from that property, you're also building an insurance policy, a security blanket against the unknown, all the instabilities we have right now in the American economy and the American banking system. If I can buy a property at a 7% cap rate, and I can drive that revenue, and cut the costs, such that based on the price I paid I worked that thing up to a 9% or 10% cap rate, that three point spread difference may be life or death down the road when properties are revalued because there's some change in the system itself.
So inflation is a scary word. Inflation is a scary economic moment. We are probably re entering that phase. At the same time as we enter an inflationary period, never forget that real estate is one of only a few things that actually do well in these periods. You don't want to drop out of the game. You might want to actually increase your holdings of real estate as you enter into inflation. But just play it safe and try and mitigate the risks. This is Frank Rolfe, the Self Storage University Podcast. Hope you enjoyed this. Talk to you again soon.