Cutting-Edge Finance Trends
|Copyright 2014 by Virgo Publishing.|
|By: Jim Davies and Eric Snyder|
|Posted on: 11/01/2005|
No matter your vantage point, it’s easy to see that self-storage has become a respected real estate product. According to the Self Storage Association, the industry is a $15 billion business, with more than 38,000 facilities nationwide; and these numbers are likely to increase. The result of this positive attention is investors and lenders are scrambling to enter the market and take advantage of current economic conditions.
For investors, self-storage offers higher returns than other commercial real estate such as apartments and industrial properties. Other advantages include low overhead, increasing rental rates, and occupancy rates that average 85 percent.
The industry is also attractive from a lender perspective. In fact, it continues to receive positive recognition from rating agencies and research analysts. The latest statistics outlined in Standard & Poor’s CMBS Quarterly Insights report show that less than .25 percent of the $4 billion in self-storage loans the agency currently rates are delinquent. Of the 30,000 CMBS loans S&P has rated over the past 10 years, those for self-storage have the lowest delinquency rate of all property types.
Due to these strong fundamentals, lenders are providing cutting-edge loan structures and aggressively underwriting new storage properties in lease-up. As a result, facility owners can lock in full loan dollars at today’s interest rates even though their properties have not yet reached stabilization. Lenders provide these loans by bridging the gap between stabilized and current occupancy with letters of credit and, in some cases, traditional earn-outs. Of course, this is subject to a property having a positive lease-up history.
Some lenders are even accommodating owners who form Tenant-in-Common ownership structures to facilitate their 1031 Exchanges. As a result of forceful underwriting, owners can even pay off their existing loans before maturity—including prepayment penalties—and take advantage of today’s low rates and unique structures.
The trend toward interest-only financing continues to grow throughout the industry. This option includes several variations: 1) interest-only during the first three years of a 10-year loan followed by a 30-year amortization; 2) five-year fixed rates with interest-only for all five years; and 3) variable rates that are interest-only for the entire loan term. Interest-only financing is usually only available for borrowers requesting loan proceeds at less than 60 percent loan-to-value.
Letter of Credit
Lenders are competing heavily for quality self-storage opportunities. You can see this in their effort to provide long-term, fixed-rate loans for facilities still in lease-up as well as a host of features that benefit storage owners. For example, if a property has maintained a strong lease-up rate, it is increasingly common for lenders to size a loan by underwriting the most current month of income on an annualized basis.
Some lenders have taken things a step farther, requiring that the current month’s net operating income (NOI) only generates a breakeven debt-coverage ratio (DCR)—provided the stabilized NOI will generate a 1.25 DCR within three to six months of loan closing. Separately, if a property has six months or more to stabilize, lenders may offer a loan leveraged at 80 percent of stabilized value by securing the shortfall of current NOI with a letter of credit. This is a major deviation from traditional underwriting that requires the trailing 12 months of income and expenses.
These new options make it possible for owners to secure a fully leveraged loan at current rates rather than taking future interest-rate risk. However, it’s important to realize lenders will take 60 to 90 days to fund a loan and expect an increasing income stream during this time. It’s also important to understand aggressive loan structures are mostly available for A-quality developments in premier locations where the lease-up has been strong and consistent. It’s difficult to obtain this type of financing if leasing performance has struggled or there are plans for new developments in the immediate market.
Still, the aggressive posture taken by the capital markets to fund less-than-stabilized facilities has had a favorable impact on the financing structures currently available. To see how investors are using the interest-only and letter-of-credit options, consider the following case study.
Storage Etc. refinanced two A-quality properties near major freeways in Los Angeles and San Diego. The facilities have been in rapid lease-up since their development and have been predicted to stabilize within 12 months. Even so, the sponsor was concerned that if he waited until the properties achieved full stabilization, interest rates would be considerably higher. He retained a reputable financing company to provide him with a maximum fixed-rate loan based on the NOI he expects to have in one year’s time.
This financing structure enabled the sponsor to pull his development costs out of the project, prior to stabilization, at less than 5.5 percent for a 10-year, fixed-rate term. The total funding was based on a breakeven DCR and 80 percent of the stabilized value. The structure also included a letter of credit that bridged the gap between the loan proceeds the sponsor could obtain today at breakeven DCR and those he could get at a 1.25 DCR upon stabilization.
As the properties continue to lease, the letter of credit will be reduced to zero. The sponsor is entitled to partial releases of the letter based on a trailing three months over the course of four years from loan funding. If he doesn’t obtain his projected stabilized NOI, the remainder of the letter will be used to pay down the loan. To increase cash flow during lease up, the lender also allowed interest-only payments for the first two years of the loan to be followed by a 30-year amortization.
A user of a 1031 Exchange who is exploring self-storage ownership as a Tenant in Common (TIC) should consider how this affects his long-term, fixed-rate financing options. Lenders have become more accommodating toward TICs and will accept them as borrowing entities provided specific requirements are met. Mitigating factors include whether the TIC members are individuals or single-purpose entities such as limited liability companies (LLC); the number of TICs allowed by the lender (usually no more than five or six); and how long the TIC can exist before it is converted into a legal entity.
Lenders of long-term, fixed-rate loans require that a TIC be comprised of single-purpose entities, not individuals. This is necessary for the TIC to be “disregarded” by the IRS and meet the requirements for a tax-deferred exchange. Some lenders only permit the TIC structure for a certain period of time, typically no more than six to twelve months. At that time, they may require the entity to be converted to a traditional LLC, with a single-purpose entity as the managing member.
Prepaying Existing Loans
Some borrowers want to know how they can capitalize on today’s low interest rates when their existing loan has a prepayment penalty. Due to concerns about rising rates, more and more owners are choosing to refinance their current loans by incurring yield maintenance or defeasance prepayment penalties. Thanks to lower rates, they can recapitalize their existing debt, increase their loan size, unlock trapped equity for other ventures and, in many cases, reduce their monthly loan payment.
It makes sense for some owners to pay a prepayment penalty if they can reduce their fixed rate of 8 percent or higher to 5.5 percent or lower. In addition, the after-tax impact of prepayment penalties may be diminished, depending on the extent to which these costs can be “written off.” Interested owners should consult a tax accountant to determine the real cost of a prepayment.
Today’s self-storage financing includes some of the most aggressive underwriting in history. The trend is fueled by the enormous amount of money available in the capital markets as well as the strength of the industry. Savvy investors should realize now is a great time to review cutting-edge options and implement a financing plan that matches their investment strategy.
Jim Davies and Eric Snyder are principals of Buchanan Storage Capital, which arranges debt and equity for self-storage owners nationwide. The company gets customers the most advantageous capital due to its significant leverage with the most aggressive storage lenders. Davies and Snyder have closed more than $2 billion in storage financing since 1994. For more information, call 800.675.1902; visit www.buchananstoragecapital.com.
Source: Buchanan Storage Capital
As of Aug. 31, Buchanan Storage Capital had sourced $400 million in self-storage loans. Of those loans, 56 percent had an interest-only component. In addition, 37.5 percent of 10-year fixed-rate loans had an interest-only period for the full term. Only 8.75 percent of the loans had a letter-of-credit component, but the company anticipated the percentage to increase significantly by year end if interest rates continued to rise. Only 12 percent of the company’s clients have refinanced their current loans by incurring prepayment penalties, but again, it was expected this number would climb with concerns regarding escalating interest rates.