American interest rates are in a state of flux, and this can present a challenge to conservative investors that like to avoid risk. In this Self-Storage University podcast we’re going to examine how to protect yourself from interest rates woes and simple steps to mitigate risk. With inflation rising and interest rates at near all-time lows, this is a recipe for disaster unless you manage this properly.
Episode 33: How To Successfully Weather Interest Rate Fluctuations Transcript
And for elevators, but it's not stress-free when you're concerned about interest rates on a self-storage facility. This is Frank Rolfe with The Self-Storage University Podcast. We're gonna be talking about how to successfully weather interest rate fluctuations. And let's first start with the simple basic maxim that interest rates over time definitely have historically always gone up and down. If you go back to the early foundings of America, back in 1776, the interest rates at that time were roughly around 7%, other times in history, such as under Ronald Reagan rates went as high as 14% to 15%, and right now you see among the lowest rates ever, they've risen a little from the historic all-time low, but down to the very low single digits. So, what does it all mean? It means that all of us who borrow money have to always be afraid of being caught in an interest rate cycle in which the rates go up and we're not prepared for it. Preparation is the key. If we all assume that interest rates can, just as they go down also go up, then clearly a smart business person, a smart real estate investor, would plan accordingly to protect themselves from the downside of interest rates going up.
But what's the problem with interest rates going up? Well, simple, as interest rates go up, the cost of borrowing goes up, as interest rates go up, typically cap rates also go up, reducing the value of your investment based on income. So there's never enough reasons why a self-storage investor would not wanna be caught in an environment in which rates are going up, so how do we plan then, how do we protect ourselves from interest rate fluctuations? Well, there are several things to think about, the first is try if you can to get a fixed interest rate. Now, there are times in American history where fixed rates looked pretty stupid. If you go back to the era of Ronald Reagan when rates were in the high teens, most people borrowing back then thought things could only get better and not worse, they didn't think that rates could ever hit 20%, and they didn't wanna really lock on a lengthy 15% mortgage when they thought, soon the rates would go back to the normal levels. So, if you're given the choice at this moment between variable rate and fixed rate, you would certainly go fix rate. I don't think any economist or any objective banker would disagree with that postulate.
Then comes a concept of the term of your loan, and I'm not talking the amortization, that's typically 25 or 30 years in length. I'm talking the term, how long the bank is loaning you the money before you have to pay them off in full and refinance yet again. Now, you see the terms on loans all over the map, three-year, five-year, seven-year, 10-year, don't normally see longer than 10-year, but it's possible with seller financing, most of your banks are gonna be in that range of three to 10 years. Clearly, in an environment in which you fear the rates will rise, you wanna get the longest interest rate fixed that you humanly can. The longest term, so if you had your choice between those options, you would clearly take the 10-year followed by the seven, followed by the five, followed by the three, but still, that may not be enough protection for you. Ten years certainly, but three years fixed isn't a very long time. Three years moves pretty rapidly, it's a good idea, if possible, if it's a seller note to see if you can get the ability to buy an extension. How does that work?
Well, you pay a one-time fee that goes towards the principle, it's not an actual cost to you to have the ability, if you need it three years in the future, five years into the future, to extend maybe for another couple of years. That means you really effectively have a loan that's two years longer than the actual face value of that term. If you have a two-year extension ride and you have a three-year note, you really have a five-year note. Now, you may not have to utilize it, you may end up in the end not needing the extension and simply refinancing into another loan at the end, but having that insurance in your pocket is gonna make you feel a whole lot more comfortable with interest rate fluctuations. You see, the key is you don't want to, when you have a period of economic instability and interest rates to be caught, when those rates are making their move, you wanna be sitting there with your fixed rate loan over a lengthy period, and that way if the rates go up, they can come down again before your loan becomes due. Now, another thing to think about when we're talking about protecting yourself from interest rate fluctuations is the concept of non-recourse debt.
Now, what is non-recourse debt? And what does that even mean? And why would that matter? Well, you have two styles of loans, you have recourse debt. In recourse debt, if you don't make your payments, then they take the property away from you and they sell it at auction, sell it on the courthouse steps and they get less money than the amount of your loan, they can come back for you personally for the difference. If you have a non-recourse loan however, they can't. The most they can get from you is the property, and then of course, whatever you had in your down payment. Clearly recourse is far riskier than non-recourse, every borrower who understands the difference is always going to choose the non-recourse option. So, what banks allow non-recourse? Well, seller financing is almost always non-recourse, conduit known as CMBS debt is also always non-recourse, but it's regular bank debt that can typically be recourse. Now, to protect yourself, if you had the capital to do it, you can typically convert with the bank from recourse to non-recourse debt, and that comes down to what's called the LTV or loan-to-value ratio.
You see, most banks, who make up loan, let's say they do 80% LTV, that means you put down 20% in their loan, you 80% of the value. However, the risk goes down for the bank as you decrease that ratio. If you have a 50% loan to value, what it means is you're putting up half and the bank is putting up half. For the bank to lose money, the property would have to decline in value more than 50%. So clearly, a bank in that case might do that loan in non-recourse figuring it's a safer bet than recourse loan at 80% LTV because then they'd have to come after you for the difference and who knows if you even have it. So if possible, to protect yourself from interest rate fluctuation, it's always great to have non-recourse debt if possible. There's one more level of risk that you should think about, it's worthy of discussion, and that is in the ultimate downside scenario, if interest rates really went crazy, as they did under Ronald Reagan, you have to start worrying about your bank itself failing, it's happened before in American history. Anyone who lived through the Texas SNL crash knows that you can have banking instability to such a level that all the banks go out of business.
I think most of the banks in Texas went bankrupt back about 1987, 1988 during the Texas SNL crash, and all the borrowers in those banks found their loans called by the failing lender or by the FDIC, the government when they took over the bank. It was a very tough situation. People who thought they had lengthy loans at fixed rates, feeling very confident in life, soon found those loans which they consider to be so safe, being called by the lender. Now, how can you get out of the banking arena, how can you take banking risk off the table? Well, borrow money without using a bank, you still have two options, one, seller financing, there's no bank involved with the seller finance deal, and the other is CMBS conduit debt. Now, how does Conduit debt, which originates at a bank, not offer the same risk regarding the banking. Well, that's because the way conduit debt works is someone originates it off in a bank, but then they sell that loan on Wall Street to the American investing public, and they're no longer then a bank.
So your loan basically, money you pay in your monthly loan goes to all those investors, but they are no longer a lending institution, they can't fail, they're not a bank, they're not under the scrutiny of the FDIC. So there are options even in the ultimate worst case scenario to avoid all bank risk, and that's why going with a loan product that is not even regulated, not even part of the American banking system. Now, will all these things go bad on you? No, not necessarily. I'm not really sure how much interest rates can really go up, we have become the world's biggest debtor, we have nearly $30 trillion in debt. The federal government has kept these rates low through what's called quantitative easing, the government is going out and buying a lot of this debt to keep those rates low. As long as they do that, they should be able to continue. And I don't think they can really let their foot much off the gas as rates go up on $30 trillion of debt, the nation would be economically wiped out. But nevertheless, it's still very important that anyone who borrows money, anyone who gets a loan for a self-storage facility fully understand the risks involved in eras of interest rates fluctuation. This is Frank Rolfe of The Self-Storage University Podcast. Hope you enjoyed this. Talk to you again soon.