Hitting the Jackpot
Copyright 2014 by Virgo Publishing.
By: Neal Gussis
Posted on: 02/01/2007



 

At some point, we probably all dream of winning a lottery jackpot. It’s hard not to imagine what we would do if we could cash in on such good fortune. Sounds like a dream. And for the overwhelming majority of us, winning the lottery is.

But some self-storage owners may be able to hit the jackpot right now. What’s more, your odds for achieving this bonanza are likely much better than picking the winning six Lotto numbers. In this jackpot, self-storage owners use their property to “cash out” rather than “cash in” on their good fortune through two attractive and viable cash-out alternatives.

If your facility is leased up and enjoying mid-80 percent occupancies at market rent levels, then you often can cash out of your property by 1) capitalizing on the current market and obtaining an outstanding sales price for your property, or 2) locking into fixed-rate financing at low interest rates and improving your monthly cash flow. With either alternative, you’ll likely come out a big winner.

Selling Pros and Cons

Before you start counting your windfall and chanting “ka-ching,” it’s vital to examine the pros and cons of selling. You want to select the right alternative for your situation and needs. Analysis can help you maximize cash out proceeds regardless of your direction. Let’s start by examining the positive aspects of selling in today’s market.

The self-storage industry is similar to other unregulated markets where the immutable law of supply and demand drives market dynamics. Today’s self-storage market can be a seller’s paradise if your property characteristics match market needs. Why? It’s the law of supply and demand. There is a limited supply of desirably located, well-maintained, stabilized properties that exceed 40,000 square feet. At the same time, investors increasingly demand these types of properties.

Relative to the total population of self-storage properties, few facilities with these attributes are ever on the market. With self-storage investment and corresponding returns so strong in recent years, most owners would find it hard to replace that investment with a future one.

However, capitalization rates (also known as cap rates, or the return on investment in the first year of ownership) have declined to the point we’re seeing rates from the mid-sixes for the highest-quality properties, to the eights for smaller, secondary facilities.

Industry Strong Man

Property demand is driven to a great extent by investment capital. Large-scale investment firms, including publicly held real estate investment trusts (REITs), recognize that real estate—particularly self storage—is a highly stable investment with limited risk compared to, for example, the volatility of some Wall Street investment vehicles.

With this recognition, more institutions are allocating funds to real estate, as proven by many larger self-storage players teaming up with institutional investors. The groups are capitalizing on the relatively low cost of funds to make strong property offers. With more institutional players in the real estate sector, competition has intensified for higher-end, higher-priced properties, thus yielding better prices for class-A facilities.

However, it’s not just class-A property owners hitting the jackpot. The overall self-storage industry is experiencing continued strength in occupancy and rental rates. Self Storage Data Services, a California-based research firm that tracks operating results of more than 6,000 self-storage properties nationwide, reports the following: National median unit occupancy in the second and third quarters of 2006 was up approximately 2 percent, while asking rents rates increased and concessions decreased.

The stability of the self-storage asset class, coupled with investment opportunities that range from less than $1 million to billion dollar-plus portfolios, will continue to attract institutional buyers, as well as individuals and smaller investment groups.

Personal Investment Objectives

While most self-storage owners look for long-term property holds, some own or build their properties for a short-term flip, typically defined as less than three years. Accordingly, many factors driving a decision to sell a property relate to the owner’s age, lifestyle and personal investment objectives.

Another significant issue relates to tax consequences of a sale, particularly when the owner has a low basis on the property. Many owners use 1031 tax laws to defer taxes by reinvesting in other real estate.

Most owners will admit there is a price point at which, regardless of personal investment objectives, they would sell their property. Some would argue today’s market is so ripe for sales that it’s simply seducing owners to move in this direction.

Timing

While cap rates are a constant topic of industry discussion, keep in mind that buyers look well beyond this one measurement when analyzing property opportunities. They also base their purchasing decisions on a combination of initial yield, stabilized yield, internal rate of return and price per square foot. The timing of a sale is important to maximize sales proceeds. A facility should be at least 60 percent occupied before going to market, and be on a continual positive trend line.

The optimum time to take a facility to market is when it has between 68 percent to 75 percent economic occupancy, provided there is no reason to believe that occupancy growth has halted and the property has peaked in performance, according to Storage Investment Advisors (SIA) research.

Downside Considerations

While all of these positive reasons may motivate you to immediately put a “For Sale” sign in front of your property, first consider two downside factors:

1. Embedded Net Operating Income: If you believe your property can achieve greater income through increasing occupancies, increasing rents or future expansion, then it may not be a good time to sell.

2. Reinvesting Profits: Owners may choose not to sell simply because they know of no other investments that will pay better returns than their current self-storage investment, although a sale will cause their liquidity to dramatically change.

Refinance or Sell?

Depending on the situation, you may have excellent reasons to hold and refinance your property rather than sell. By doing so, you won’t be able to “take the money and run” after a sale closes, but you can still be a financial winner by drawing cash out of your investment or improving your cash flow, thus putting more money in your pocket each month.

Let’s examine some of the pros of refinancing. Based on your property’s operating performance, you may well be able to cash out of your investment. In banking terms, cash out means you’re seeking a loan amount greater than your existing loan, and in some instances, even greater than your initial investment. The key advantage is the money you receive through higher leverage will not be currently taxed.

While today’s headlines typically emphasize higher short-term interest rates and increases for adjustable rate mortgages, longer-term lending rates actually decreased as 2006 came to a close. By choosing the most attractive rates available, you can likely lock into a fixed interest rate below six percent.

We are now experiencing an inverted yield curve, which means long-term money is currently available cheaper than shorter term funding.

Higher Leverage

Securitized lending—also known as conduit loans—now comprises more than 20 percent of all real estate loans nationwide. The primary reasons for this growth relate to the attractive fixed rates, leverage levels and non-recourse features of the loan products.

Today’s conduit lenders routinely lend 80 percent loan-to-value on self-storage properties. This high leverage, combined with the lower cap rates noted earlier, allows self-storage owners to obtain unprecedented higher-loan leverage than anytime in recent history. Many local lenders are also aggressively making loans in the 75 percent to 80 percent range.

In addition to obtaining a lower interest rate through a refinancing, you can also improve monthly cash flow by increasing your amortization period up to 30 years. Building on a residential mortgage trend, many commercial lenders are also offering initial fixed-rate, interest-only periods to self-storage property owners, giving you yet another avenue for improving your monthly financial position.

Assumable Mortgages

Most long-term fixed rate loans are assumable for a 1 percent fee or less. Therefore, if you lock into a low rate and rates subsequently move up, you may be in a position where the existing financing adds value to a subsequent sale.

Downsides of Refinancing

Like the sales route, refinancing does have several cons affecting self-storage owners. Let’s look at short-term loans.

Shorter-term or variable-rate mortgages based on Prime or LIBOR have increased in the past two years. Many of these loans are being offered from 7.5 percent to 9 percent today, compared to less than 6 percent for long-term fixed rate financing.

For example, if you want a flexible mortgage with either a minimal prepayment penalty or none at all, or if you are unable to obtain a low-interest, fixed-rate loan, then the current market is not optimal for refinancing. On the other hand, you and your financial advisors should examine your personal situation to determine whether better terms will crop up in the future.

Low Occupancy

If your self-storage property has stumbled at an occupancy level of 65 percent or less and you can’t seem to get over the hump, new financing options may be limited. Lenders will be critical as to why the property is not performing better in today’s strong market. This may be a situation where selling the property may be a more viable alternative than refinancing.

You don’t want to get in a trapped-equity situation. If you decide to refinance with a fixed-rate loan, be sure to maximize your leverage because prepayment penalties are usually associated with fixed-rate financing. Many times, secondary financing is also prohibited, depending on the source of funds. Therefore, you’ll want to consider how much equity will be “trapped” over the course of the fixed period. You may want to choose a shorter-term loan depending on how much trapped equity you’ll encounter in a fixed-rate loan product.

Move Cautiously

Determining whether your jackpot is coming in the form of a sale or refinancing depends entirely on your property’s operating results, physical characteristics, local market conditions and your personal investment objectives.

Don’t get ahead of yourself and start dreaming giddily. As a real estate investor, consider stepping back and periodically reviewing the big picture. Move cautiously and analyze all your options to select the most profitable course for your specific needs. By doing so—especially in conjunction with counsel from mortgage banking and sales brokerage professionals—you’ll be more likely uncover the best way to draw cash out of your self-storage investments. 

Neal Gussis is a principal with Beacon Realty Capital, a Chicago-based commercial real estate financing firm, where he directs the company’s self-storage lending programs and supports self-storage owners nationwide with their financing needs. He can be reached at 312.207.8240; e-mail ngussis@beaconrealtycapital.com