Last week, as a self storage person, not an economist, I shared my ideas on inflation.
Inflation is the driver of what is happening to our economy at this moment in time.
I also suggested, to whatever degree possible, that we put aside our political leanings because these create the reality we experience as we attempt to draw conclusions from what we perceive from data and our observations.
Ultimately, this is impossible. But I do think if we realize that perhaps no person, political party, tribe, economic or belief system has achieved the ultimate “truth,” and that just maybe all of them have some correct aspects to them (as well as incorrect aspects); we can begin to see different things, draw different conclusions, and make different moves as business owners.
Or just maybe I am completely full of it.
Most likely, the latter.
But I will pontificate anyway on what I see as I look at economic data and peer into the future.
Last week, I attempted to convey what I saw as I researched the causes of our current inflation.
I feel the “causes” are important because I felt if I could get at some real sources of the inflation, I could better understand if what the Federal Reserve is doing will actually impact inflation.
I see four main causes of today’s inflation. If interested, you can click here and read or watch to see what they are.
Economic Landscape
So, if inflation is the train barreling down the tracks, the economic landscape on either side looks like this:
- Credit is tightening up. Lenders, especially banks, are uncertain. When uncertain, credit becomes harder to get. This is a recessionary indicator.
- Consumer confidence was down in 2022 to approximately 66%. It rose slightly in early 2023 with the most optimism in nine months because of data on healthy incomes and easing inflation, but my guess is it bounced down again as the Fed signaled in Feb. that more interest rate hikes are coming. This is a recessionary indicator.
- Although consumer savings are still higher than most previous times, they are down somewhat from a year ago, primarily due to inflation. This is not a recessionary indicator.
- Real income is higher (even after adjusting for inflation). I suspect primarily due to worker shortages (See last week’s episode). This is not a recessionary indicator.
- Real household net worth is still high compared to previous times. This could decrease in 2023 because household net worth main drivers are home values and the stock market. This is not a recessionary indicator.
- Unemployment is still low (discussed last week). This is not a recessionary indicator.
It is a mixed landscape.
Consumer spending still tends to be high. Thus, unlike other times when recessions are looming, demand for goods and services remains high.
If you did a T chart For and Against a recession at this moment, it might look something like this:
For Recession:
- Tightening consumer credit.
- Lower consumer confidence.
- Inflation
Against Recession:
- Still strong demand for goods and services.
- Consumer spending remains high.
- Low unemployment.
In many ways, this is uncharted territory.
The largest issue I see looming is the Federal Reserve’s goal of getting inflation to 2%.
From what I can see, energy costs are going to stay high.
As discussed last week, unlike most commodities, when demand goes up, production increases.
This won’t work in energy. Although the US is the largest energy producer in the world, we are at capacity in production. Any further investment in production takes around seven years to generate increased production.
Current oil reserves are low, and I don’t see energy companies putting profits into increased fossil fuel production, given the obvious issues they create and the fact that the world is moving away from them.
Even the oil companies know this. Already, Norway has 99% of its energy generated by renewable energy sources.
In the US, it is about 20% and growing. Where would you put long-term capital investment if you were an energy company?
My guess is they realize the long-term investment in fossil fuel production is money they will not see a good return on.
So, for now, I think energy costs will remain high. There will be some ups and downs in pricing, but overall, high.
Given energy costs are a primary driver for inflation, I don’t see the 2% inflation rate happening any time soon.
So what will the Fed do?
Who knows?
My guess is the Fed will continue to raise interest until there is a real slowdown in the economy. Perhaps not a full recession, but they have got to see developments, companies spending capital dollars, and hiring much slower than it is now to feel like they are impacting inflation.
Then rates will slowly come back down.
It occurs to me like hitting my child over the head with a hammer to make their headache disappear.
I am fairly sure our 40-year run of low interest is over.
My guess is interest rates will rise, then eventually retreat to mid 5’s to mid 6’s.
Self Storage
Now nothing I saw is guaranteed to be correct, and I most likely have some holes in my predictions.
But as a business owner, I have to attempt to do this to make the best moves I can today, given what I see in the future.
So here is what I am focused on in regard to self storage.
First, we all know self storage has historically done well in recessionary times compared to other income-producing real estate assets.
It most likely is the same overall as the upcoming Fed-created downturn.
However, some trade areas will be hit particularly hard.
As an industry, we have never gone into an economic downturn with this much inventory in the market.
I am hesitant to do extensive construction self storage projects today unless it is in a vibrant trade area. Even then, I would be slow to act and fast to walk.
You see many “development opportunities” and “C of O” projects hit the market now.
Many of these are developers who (1) underwrote in a different environment when the inflation train wasn’t picking up steam and/or (2) people who lost their funding, either equity, debt, or both.
Many of these “opportunities” on the market are attempts to make a profit on the work they have done entitling the property. Some will work for us small investors, but most won’t at the current offering prices. There may be some good deals here now, but I bet there will certainly be more.
Just be extremely careful of the trade area.
I also think we will soon start seeing “distressed” storage hit the market.
One rarely sees that now, but I predict we will start seeing some.
One stat I heard at another type of real estate conference I recently attended was that as much as 25% of the CMBS loans rolling in the next 24 months will not qualify today for a new loan using the same underwriting guidelines as before.
That is an incredible stat if it is anywhere near true.
I also am guessing that could be the same for regular bank loans that were written back in 2016 through 2018, which are now rolling and have to be refinanced.
I would pay attention to these deals hitting the market. Often, nothing is wrong with the asset. The current owner either has to put more equity into the deal or sell it to someone who can get a new loan. Many owners just don’t have another $250,00 or so to put in the deal to get the debt coverage ratio to the required proportion, so they have to sell a perfectly good asset at a price where a new loan can be put on it.
As you can guess, I still love expansions and conversions. I like both because I have income during the construction period.
For expansions, it is the current storage rental income. For conversions, we rent part of the building out for another use while we construct storage and lease it up.
We are still rarely able to purchase existing self storage without some additional space being added. Even though CAP rates have risen, they are still below interest rates. Some kind of major value add play is required. For us
Perhaps that will change soon.
Because inflation is not going to hit 2%, in my opinion, I think interest rates will rise over the next year or so.
If at all possible, I am trying to negotiate with banks today that during the construction phase, which is usually interest only, we let the interest rate float. Yes, it will most likely go up a few more times during our interest-only period. But I am betting that when we get to the point where the loan starts amortizing, rates will be lower than they are now.
The best guess is that when the slowdown hits, rates will incrementally drop and land in the 5% to 6% or 6.5% range.
We are trying to negotiate floating during the interest-only period, then lock in when amortization starts.
For the first time ever, I use two different interest rates in our proformas, higher on interest only then around 6% to 6.5% when amortization starts.
Who knows, but my best guess is that is what will really happen.
Also, if at all possible, we try to index interest-only period to prime (have no choice in almost all cases), but if at all possible, have the amortization rate be indexed to five or seven-year treasury notes. Some lenders can and will do this. Treasury notes are almost always lower than the prime rate.
Conclusion
My goal in writing this and the last episode was not to give predictions, but to see how correct I end up being.
We live in a very divisive time where political opinions run strong.
As humans, we have a need to join tribes. Political parties are tribes, and they tend to feel that their world views are right, and that the views of other tribes are wrong.
As business owners, we take this unconscious bias and world view into our interpretation of economic data, which can skew our perspective.
But as much as possible, I hope we can begin to realize that the world is not black or white, and that “we” and “them” are not necessarily either right or wrong.
In the end, the economy does not care about our beliefs; it just moves along. Let’s try to move with it. There is opportunity in every phase of the economic cycle, regardless of our beliefs.
