Self Storage University Podcast: Episode 87

When Will Higher Interest Rates Lead To Distressed Deals To Buy?

It’s no surprise that self-storage facility loan interest rates have gone up to the highest level in nearly 40 years – and in only 18 months. And there has to be a correlation between these increases and the arrival of loan defaults on the part of many facilities. But when? And how can you put yourself in a position to buy these deals when they come to pass? That’s the topic of this week’s Self-Storage University podcast.

Episode 87: When Will Higher Interest Rates Lead To Distressed Deals To Buy? Transcript

There's no question that America is in a real mess right now. You've got all kinds of instability, all kinds of insecurity. You're seeing the highest interest rates that you've had in the United States in the past 40 years, and you're seeing interest rates that have moved up faster than they have at any time since the past 40 years. And because of all these interest rate movement, you're seeing two alarming factors in the self-storage industry: Higher cap rates which devalue properties bought at lower cap rates, and much higher costs on mortgages going forward when those loans come up for renewal. This is Frank Rolfe from the Self-Storage University Podcast. We're gonna talk about all of the distress that should be brewing out in self-storage, and how that will then unfold as far as opportunity to buy self-storages that can't cut the mustard based on the new lending environment.

Let's first go over the crime scene of what happened. You had interest rates that fell after the Great Recession all the way down to nearly zero. The Fed funds rate was often and for the longest time around 0.25%. And then Jerome Powell, in the first quarter of 2022, decided to try and battle inflation by raising those rates at a higher level than anyone had ever seen since President Ronald Reagan back in the '80s, nearly a half-century ago since this has occurred. And he pushed those rates all the way up by five points in roughly 18 months. That's an insanely fast progression. And when you do things like that, you know there's a by-product of doing that, and that by-product is you will have some degree of failure of existing deals that were paid for before those rates were that high. And that's exactly what it will happen.

Let's assume that you'd bought a self-storage facility at a 4% cap rate just a few years ago prior to Q1 of 2022, and now let's assume interest rates have risen on that loan from 3% or 4% to as much as 7% or 8%. The new cap rate is therefore going to be somewhere between 8% to 9%, and that means that the value of what you pay for that self-storage facility is down about 50%. If you bought something for $2 million at the 4% cap, now, it's only worth a million dollars at the 8% cap rate. So that then launches a problem for people who bought parks during that period. Because when those loans come due, the values are much decreased, and as a result you can't get a new loan. When you go to get a new loan they'll say, "Okay, well, let me see your appraised value. Let's get an appraisal done," and when the appraisal comes in in half of what you paid, the bank is gonna shake their head and say, "Look guys, I can't do a loan for anywhere near what you got, but I could do a loan for say 70% or 80% of that new appraised value." So you just got to kick in a million dollars of cash to cover that shortfall. And those who don't have millions of dollars laying around to cover the shortfall are then going to have their loans go into default.

Similarly, if you had a mortgage on a self-storage facility, there was on the books that say 4%, and now interest rates have risen to 8%, can you even handle the monthly mortgage payment? Some of those loans are variable so they've already gone up, which puts a lot of pressure on people. Others are fixed rate, but when those loans come due and they typically come due and no longer limits than 10 years from inception, then what happens? You can't afford the new debt. New debt payment is twice what it was before. You might have been marginally profitable before and now you're running in red ink, this giant sea of red ink. So what happens in both of these scenarios? Basically the loan goes into default unless the borrower has the money to try and prop it up. And most people are not going to have enough money to prop that up; that is like trying to hold back the Mississippi River.

So what happens then when things go into default mode? Well typically, based on what we've seen in prior recessions, there is a little bit of a delay. If you had a property when the economy went bad in 2007, 2008 during the Great Recession, you didn't see a lot of those deals they got in trouble with lenders coming to the market until about 2010, 2011. There's about a three- or four-year lag. Now, why was that? Why was there such a lag going on? Well, the problem is banks don't like to take properties back. It's embarrassing to them, so they don't like that. So instead, they'll often do what's called "extend and pretend." That means you just keep making your payments while they try and ponder what the next move could be. Other people would have deals that were marginally upside-down and the bank would try every way they could to try and save that deal from going into foreclosure. Because again, banks don't like that stuff. And then when they do ultimately go into foreclosure often the owner of that self-storage facility will try and fight it by filing bankruptcy or some legal action to try and delay the process, hoping somehow the race will go down and life will go back to normal.

So the first thing on the distress deals that you'll see is there will be a delay. The second thing you'll see on the distress deals are they come in basically two different equivalents. You've got the pile of deals that have had some kind of term default because they couldn't get the loan a new loan made, but they're still in fairly decent condition. They have financial information, and they've got some degree of occupancy. And then you have another group who are ones that just completely fell apart. The person walked off the job, quit, gave up; the borrower became hostile with the lender, and as a result there's no financial information, and those things can have occupancy rates that are just dreadful. It could be 20%, 30%.

Now, where do you find these deals? Well, a lot of those deals end up on a website called A lot of lenders, when they have to finally throw in the towel and give up, they wanna get them off the books quickly, and they'll put it on a website designed just for people who buy distress things, and is probably the primary site for that use. But you also see those things popping up on all kinds of listings for self-storage facilities, sometimes with big bold letters across the top saying "Foreclosure, Property and default, must sell quickly," with the addition of OBO "or best offer" on the price. Because the lenders wanna move those; they don't wanna sit around when those deals come up, they wanna get them out the door quickly.

Now, if you're looking at deals that are in distress, and particularly in auction, here's what you need to know about buying self-storage facilities at an auction. When you buy in an auction, you typically, if you win the auction, have to put down 10% that very day, and the other 90% within 30 days. You can guess the predicament here. Can you really get a loan to get it done within the full 30-day period? And if the answer is, "No, I don't have any faith at all I can do that in the troubled America," then instead, what you have to do, you have to buy for all-cash. Do you have the cash to buy it for all-cash? And if the answer is no, I don't have the cash to buy for all-cash and I'm pretty confident I can't get a loan within 30 days, then you probably should not be trying to buy things through the auctions method.

However, the deals that are sold through brokers typically come with normal exam periods for due diligence and financing contingencies. That's a much more sane way to buy deals, albeit typically not as a low a cost as you will see in some auctions, but nevertheless, it gives you the time to get the job that done properly. The bottom line to it all is there's no question you will see a lot of distress in the self-storage industry. It's happening right now behind the scenes, you're just not hearing it or seeing it. But you will hear and see it when it manifests itself in listings of people who really need to get things out the door, and there's typically a lot of opportunity in those hardened times, because one person's problem is another person's opportunity.

This is Frank Rolfe of Self-Storage University Podcast. I hope you enjoyed this. Talk to you again soon.