Is Your Self-Storage Loan Overleveraged?
|Copyright 2014 by Virgo Publishing.|
|By: Shawn Hill|
|Posted on: 05/04/2009|
Around this time last year, I wrote a column for Inside Self-Storage titled, “The Credit Crunch: From Wall Street to Main Street.” Its two main points were that the economic situation was far worse than expected, and the credit crisis had extended beyond Wall Street capital markets to affect most consumers. A year later, I think few would debate the article’s premise.
As the recession deepens, I recall one of my mentors—a wise and experienced credit officer—telling me, “It is not until the tide goes out that you learn who has been swimming without their trunks on.”
Mortgage bankers field daily calls and e-mails from people wanting to better understand the current lending market. Media coverage has left self-storage owners and investors with the impression that banks are not lending. Meanwhile, owners with immediate financing needs are concerned about finding a lender who is willing to support their transactions. Perception is reality in our world, and the lack of real information, coupled with a healthy dose of headline risk, has markets paralyzed with fear.
The fact is banks are lending and deals are getting done in today’s market environment. Make no mistake though: Lenders are much more selective. There are fewer of them, and there is far less availability of non-recourse capital. Today’s deals likely bear no similarity to those transacted 18 months ago, but there is certainly money available for qualified transactions if you know where to look and have realistic expectations.
Banks are underwriting an average of 65 percent loan-to-value (LTV) and applying much more stringent underwriting criteria. To arrive at cash flow, they analyze a property’s extended history (trailing 12 months or more), use conservative expenses, and make sure amortizations are short enough to ensure some pay down of the balance over the loan’s life. This generally means the lender’s idea of reliable underwritten cash flow is different (read: lower) than the owner’s perspective and, in some cases, even the actual operating results.
The most challenging situation we face is many loans made in the past five years are likely overleveraged by today’s lending criteria. If you have a loan maturing, this can be a significant problem that results in the deal requiring an equity infusion to rebalance the capital stack.
Alternatively, if you are selling your property, you may encounter a bid/ask spread where the offers might not measure up to your expectations in light of financing parameters driving the deal. In this market, it is ultimately the underwritten cash flow that drives the loan amount. When the dust finally settles on the cap-rate debate, loan dollars are more likely constrained by debt-service coverage as opposed to LTV.
Many storage investors could ultimately find themselves in a situation where there are not adequate loan proceeds available to refinance the current outstanding loan balance. Overlay this with the new leverage standards and tougher underwriting criteria, and it becomes fairly obvious there is an equity gap in the capital structure in many of these maturing deals that will need to be filled.
If you have a loan coming due or you simply want to complete a “quick and dirty” analysis to determine if your loan is overleveraged, you can easily conduct a “stressed loan constant sizing analysis” to gain a better perspective of where you stand and what a lender is likely to conclude. The nice part of this do-it-yourself loan-sizing technique is it eliminates any debate about cap rates from the equation.
Start the calculation by taking your outstanding loan balance and multiplying it by 10 percent. The result is the amount of your debt-service payment when using a 10 percent loan constant. Next, take your underwritten net cash flow (revenue minus expenses, not including debt service or depreciation) and divide by the debt-service number you calculated.
It's critical to use a bank underwriting methodology to derive the cash-flow number, which means you need to include a management fee, even if you do not have one. Your revenue should include a realistic market vacancy with operating expenses between 30 and 40 percent. If the debt-service coverage ratio (DSCR) on a 10 constant is less than 1.25, there is good chance you may be overleveraged.
The following example shows two loan scenarios and helps explain the mathematical calculation.
Obviously, there are many factors that make a real scenario much more complicated. We could debate endlessly about cap rates, values, available leverage points, etc., and I will be the first to admit every situation is unique and requires special examination. The purpose of the exercise is to help you consider your individual deals and provide a useful tool to quickly determine potential hurdles in any near-term refinancing.
If after completing the stressed constant sizing analysis you feel your deal may be overleveraged, here are some useful suggestions. These tips are offered with the caveat that, at the time of this writing, there is no Congressional guidance requiring banks to work with borrowers on their overleveraged commercial loans, unlike in the residential mortgage market.
Be proactive. If you have a loan coming due in 12 to 24 months, be proactive and consider approaching the market now. Even if your existing rate is lower than rates available, it is possible this economy could create a declining trend in your operation and cash flow over the near term ... and that will be a harder story to tell when property refinancing time arrives. If 2008 was a strong year for your property, tell that story now to lenders to capitalize on these results.
Get started sooner rather than later. Don’t wait until the last minute to approach your bank about a storage loan coming due. Regardless of whether you think there might be a problem, meet with your bank or mortgage broker as early as possible to discuss the situation in greater detail. Deals are typically taking longer to complete in this market. Time can be a great asset, particularly when working on transactions with challenges. You can often ferret out those challenges by strategizing with a professional on how to improve the situation in the loan’s remaining time.
Develop equity shortfall alternatives. If you think there might be an equity gap in the transaction, start working now to develop some options. Lining up equity investors can be a tedious and time-consuming process, and if you wait until you are out of time, your negotiating position may be compromised. More important, equity is an expensive alternative. Depending on the situation and the time remaining, you may be able to sweep excess cash flow and accumulate funds to help bridge the gap. Recognizing the problem and developing an action plan are half the battle.
Consider loan workouts and modifications. Some banks will be forced to extend or restructure their overleveraged loans, but will likely do so unwillingly and with penalty. Proactive customers who can demonstrate a clear track record of diligent effort in attempting to refinance a loan will have the upper hand.
If you can demonstrate to the bank that you have worked with a broker or actively marketed the deal but are unable to find a workable solution, it will go a long way toward getting the lender to recognize the problem and cooperate on a workable solution. Alternatively, those who wait until the last minute and throw their arms up are more likely to find a lender with little, if any, sympathy.
With the passage of President Obama’s economic-stimulus package, many are once again cautiously optimistic that the worst is behind us. Let’s hope that is the case. But in the meantime, you might want to do a little homework to determine if you’ve brought your swimming trunks along for the dip.