Creative Debt Structures
|Copyright 2014 by Virgo Publishing.|
|By: Joe Maehler and Scott Sweeney|
|Posted on: 11/07/2006|
It’s still a borrower’s market. The best news is self-storage commercial mortgage backed securities (CMBS) hold one of the lowest default rates of all real estate asset classes including office, industrial, retail and multi-family.
Lenders once considered self-storage unappealing because of its month-to-month tenancy as compared to long-term commercial tenants. Now it’s considered an acutely safe and attractive investment, especially when combined with a pool of large commercial real estate loans.
Lenders are clearly attracted to self-storage, as evidenced by the compression of CMBS spreads over the past four years. Financial institutions dropped pricing to stay competitive in today’s capital markets and win over self-storage borrowers. Since January 2002, spreads have essentially been cut in half (as shown in the “Basis Point Spread” graph below).
At the same time, the 10-Year Treasury note went from 5.04 percent to 4.64 percent, and now is back to the 5 percent range (as shown in “Interest Rate Comparison” graph below). This drastic reduction in fixed-rate spreads clearly shows how lenders are reducing profitability to keep pace with new competition entering the self-storage debt business.
Construction and bridge loans have also become highly competitive in pricing and structure because of the influx of capital into the real estate debt markets. New lenders enter the self-storage debt game every day. Once a niche asset class nearly impossible to finance, self-storage has become a commodity business.
Breaking Away From the Pack
Experienced lenders are now finding creative and aggressive ways to differentiate themselves from newcomers. They’ve developed “on-book, fixed-rate” bridge loans and high-leverage, non-recourse construction loans. These structures offer a unique financing alternative that can be highly profitable for any borrower.
Many storage owners are familiar with fixed-rate loans limited to a 1.25 debt coverage and a 75 percent loan-to-value with little prepayment flexibility. Few are aware of a new option: the non-recourse, fixed-rate loan placed on the property prior to stabilization at a below-break-even debt-coverage ratio. Known as an on-book, fixed-rate loan, it yields up to 85 percent loan-to-value leverage.
Similar to a CMBS note, it’s priced over the U.S. Treasury, and the maximum term is five years versus a typical 10-year CMBS loan term. Further, the on-book loan is typically 40 to 50 basis points higher in spread, the on-book note is interest only and there is no principal pay-down for the term—whereas a CMBS note is typically amortized on a 25- to 30-year schedule.
In a nutshell, the two most compelling reasons to consider an on-book fixed rate note instead of a standard CMBS loan are the ability to fund the loan proceeds below a breakeven debt-coverage ratio and flexibility in prepayment capabilities.
Fixed Rate, Flexibility and Structure
CMBS loans are typically constrained by debt-service coverage with a 1.2 to 1.25 debt-service coverage ratio on proceeds. Simply put, the property’s net operating income (NOI) needs to be 1.20 to 1.25 times the debt service.
For example, say the five-, seven- or 10-year T-bill yield is 4.9 percent and the CMBS note spread is 120 basis points. This results in an interest rate of 6.1 percent. The loan constant (the combined pay rate of the note, principal and interest payment) utilizing a 30-year amortization is 7.27 percent. For a $5 million loan, the debt-service payment is 7.27 percent x $5 million = $363,500. Suppose the required debt-service coverage is 1.2: To qualify for a $5 million fixed-rate loan the property must have an NOI of at least $436,200.
The on-book, fixed-rate loan doesn’t need this NOI level, nor does the property need to perform at a level covering debt service. The loan can structure an interest reserve to cover payments while the property continues to stabilize. This interest reserve is most significant because self-storage owners can lock in long-term fixed rates prior to stabilization, eliminating interest-rate risk earlier. The property only needs to have a strong increasing income trend or good repositioning business.
One of the biggest complaints about CMBS loans from experienced borrowers is it’s nearly impossible to prepay it without incurring heavy defeasance or yield maintenance costs in a flat or decreasing interest-rate environment. Outside of transaction fees, to prepay a CMBS loan without penalty, interest rates need to increase by almost double the spread of the original note. Conversely, the on-book, fixed-rate note can be prepaid without any penalty if rates increase by 20 basis point spread (bps) or more.
In certain cases, the on-book, fixed-rate loan can replace the standard LIBOR floating-rate, bridge loan for acquisition of properties or portfolios that are in transition or have a value-added business plan. For acquisitions or refinances of unstabilized properties, the on-book, fixed-rate loan can be a valuable bridge loan with interest-rate protection. It can provide more proceeds, interest only for the loan’s term and strong prepayment provisions.
From a borrower’s perspective, it can eliminate interest-rate risk earlier than anticipated and provide an extremely flexible alternative to a conduit loan or bridge loan. The only drawback is most lenders offering it have a minimum loan size per property of $10 million.
Non-Recourse Construction Financing
While experienced lenders are using balance sheets to capture fixed-rate, self-storage debt and bridge financing, they’re also finding new ways to capture the construction-debt market.
For some time the leverage, term and pricing of a construction loan was based primarily on the strength of the borrower’s financial statement, with a focus on net worth and liquidity, and had little to do with the actual value of the deal. Traditional construction loans were priced from 200 to 300 bps over 30-day LIBOR, maxed out at 80 percent loan-to-cost leverage and required a full guarantee from the borrower. However, as the construction lending market continues to grow more fluid, lender’s spreads have compressed and some now offer a new non-recourse construction loan with an 85 percent loan-to-cost, typically priced around 300 bps over 30-day LIBOR.
An experienced sponsor (with development pipelines in excess of $20 million within 18 months of the first loan funding) can qualify for up to 95 percent loan-to-cost financing through a little extra loan pricing and costs. This allows experienced developers who are short on cash to build and own their own portfolio without giving up part of the deal to an equity partner.
The self-storage industry has evolved into an investment favorite, which has prompted lenders to create new avenues of financing. To maximize revenue for each investment, self-storage owners must stay current with new loan structures in today’s capital markets. Shop wisely and watch your investments prosper.
Joe Maehler is the capital market specialist and Scott Sweeney is vice president of Buchanan Storage Capital, a provider of capital to self-storage owners nationwide. The company has a $2.5 billion track record in storage financing, closing more than $450 million in 2005. Parent company, Buchanan Street Partners, a leading real estate investment bank, completed more than $10.5 billion of transactions since its inception in 1999. For more information, call 800.675.1902; visit www.buchananstoragecapital.com.