There is a lot of grinding of teeth and wringing of hands around rising interest rates and buying self storage today.
I don’t want to minimize the impact higher interest rates can have on projects and underwriting them.
Today, more discipline in underwriting is required than ever. But one should always practice underwriting and acquisition discipline.
That is one reason I got to the door of executing a fund twice and didn’t pull the trigger. I could not see myself deploying that much money into deals that I was having a hard time underwriting.
Just me, though. I am sure other factors were at play like I didn’t want to be in that business.
However, this episode is not about me and my relationship with running a self storage fund.
I will make what may seem like a counter-intuitive statement but hang with me for a while.
During inflationary times, I like to put as much debt on a project as I possibly can.
What?
Sure, I have to make sure its cash flows meet the minimum debt coverage ratio for the bank when stabilized. But let’s back up and take a higher view.
Even with higher interest rates, which I don’t think will stay this high for an extended time (may not get back to mid 3’s or low 4’s), but bank debt is still the lowest cost money in any self storage deal.
And what usually happens to real estate during inflationary times?
Because costs are rising, income rises too.
I was thinking about my parents. In around 1969 or 1970, they bought a house for $46,000.
I spent my teenage years growing up there, and after I became an adult (my wife still questions me on that statement), that is where we had every Christmas, Easter, Thanksgiving, etc.
When they died, we sold that house for over $1 million.
Let’s act like Einstein and do a mental experiment, only instead of physics, let’s do economics.
Imagine they bought that house with a note for $46,000. 100% leveraged. And let’s say they paid interest only on that note—interest only for 36 years.
When they bought the house, they were 100% leveraged. When they died, they were 42% ( a little less) leveraged in this experiment.
What happened?
Sure, location, comparable sales, and all the like are involved, but in a very real sense, the only thing really going on is inflation.
Sure, in this example, my parents needed to be able to pay the interest payment when they started.
It might have even been a stretch at first for them if this was what they would have done.
But very soon, especially during the 1970s, the interest payment would begin to seem low with that inflation.
Now translate that thought experiment to self storage today.
What if, after doing an expansion and leasing up, we are just beginning to hit a 1.2% or 1.25% debt coverage ratio? Our cash-on-cash returns are, let’s say, barely double digits.
Faster than it has been in the last three or four decades, our income is going to rise. If we manage the asset well, the NOI is going to rise and most likely rise faster than NOIs rose in the last decades.
This requires knowing our income growth rate and our expense growth rate. There may even be a year or so where expenses rise faster than income, but my experience through 2008 -2012, those years were just a few, and we soon made up for it.
Inflationary time requires much more hands and energy on the dials and leavers of our business. It requires discipline and thoughtful action as to what is the next step and where this facility is in the process of going from where we started to where we are going.
But I am taking on this current inflationary time to use inflation to my advantage as much as possible. For me, that is putting as much debt as I can reasonably do to hit the minimum bank and business plan benchmark numbers when my value-add play is complete.
These are just my thoughts today, and I am no expert in economics. So, take everything I say and research it for yourself.
Execute a strategy and plan that works for you, but know I am excited about the opportunities that await us in 2023 in the self storage space.
