Properly Structured Construction Financing
Copyright 2014 by Virgo Publishing.
By: Richard M. Kerwin and Devin S. Huber
Posted on: 11/07/2006



 

While most commercial real estate lenders understand retail, office, multifamily and industrial property types, fewer comprehend the nuances of self-storage construction financing.

All too often, lenders apply financing parameters from other property types to self-storage with detrimental consequences to owners. For example, a lender might assume your proposed property will achieve a stabilized capacity in the same time frame as other commercial real estate property types. This leads to trouble—additional cash equity or collateral pledges, loans maturing before the property can be refinanced, and rapid loan amortization.

Understanding construction financing options and structuring the best loan suited for your development starts your project on the right foot.

Securing the Proper Lending Source

Local and regional banks are frequently the first stop for financing because of the property owner’s prior relationship with the bank. These lenders understand the real estate market’s dynamics and localized risks, but they may not be experts on self-storage construction financing.

Consider expanding your search by talking with other area lenders. This can lead to another local lending relationship and, if nothing else, competition for your financing may produce better offers.

Another avenue for construction financing is the commercial mortgage broker community. Because few construction lenders market themselves directly to the self-storage industry, commercial mortgage brokers have assumed a much larger role in recent years helping developers, buyers and owners obtain property financing.

Mortgage brokers work with multiple lenders familiar with self-storage. With no ties to a single financing source or loan product, brokers search a much larger universe of construction loan programs to help developers secure a loan with the best overall terms, saving money and avoiding unnecessary future refinancing costs—especially pertinent with today’s rising interest rates.

Assessing Projections

Now that you’ve targeted potential sources for your construction loan, it’s time to prepare for the financing process. If you’re a first-time self-storage developer, most lenders will require a feasibility study conducted by an independent third party to indicate if the market can support the proposed facility.

Expect a feasibility study to address the following questions:

  1. Zoning: Is the parcel properly zoned for self-storage? Are any variances needed?
  2. Competition: Who are the competitors? How many are there? What do their facilities look like and what are their occupancy levels?
  3. Depth of the Market: Based on the surrounding area’s demographics and growth trends, how much additional selfstorage square footage can the market absorb?
  4. Absorption: What will the anticipated lease-up rate be given current and future market conditions?
  5. Pricing: What is the likely rent based on your unit mix?
  6. Construction Cost Analysis: How do your construction costs compare to industry averages?

Making Your Case

Just as you would don proper clothes for a job interview, you need to dress up your development for proper presentation to potential lenders. Your clothing of choice in this case is the loan package.

Begin your loan package with an executive summary outlining the package’s contents and your desired loan terms. At the very least, the executive summary should specify the requested loan amount, length of loan term, interest rate and total project cost. And remember a properly structured construction loan should always include a contingency for unforeseen events, as well as reserves for operating deficits and interest to be paid during the construction and lease-up period until the project exceeds the breakeven point.

Following the executive summary, several other elements should be included in your construction loan package:

1. Construction Budget: A budget identifying a project’s total costs gives a lender comfort that all aspects of development have been considered. It should list land and related entitlement costs (or present value if you’ve owned the parcel for a long time), hard costs (what’s needed to improve the site and build facilities), and all soft costs (legal, zoning, architectural, financing, engineering, environmental and developer profit).

2. Loan Amount to Cost: This is the percentage of total costs the bank will lend. Lenders generally require 20 to 25 percent cash equity in a deal, resulting in a 75 to 80 percent loan-to-cost. Some lenders recognize an increase in the land value as the equivalent to cash for equity requirement—if the land that has been owned for a long time or was acquired with one zoning classification but reclassified to a fully entitled parcel for self-storage development.

3. Loan Term: Historically, construction loans are for a 24- to 36-month period, with the expectation a developer will refinance the loan at maturity. Some construction lenders provide mini-permanent (“mini-perm”) or permanent loan after the construction period. It might look like it offers greater flexibility at the maturity of the construction and lease-up period, but be cautious: You may be required to convert the loan to a mini-perm with the construction lender, or pay an exit or prepayment penalty if you explore other options or sell the property in the future.

4. The Pro Forma (Income and Expense Projections): A loan package’s most important component is the pro-forma, supporting the economics behind the project. It should detail anticipated monthly revenue and expenses from construction completion through lease-up. To successfully obtain a loan, you must demonstrate the project will be profitable; sufficient income to pay the mortgage will exist; and lease-up will be fast enough to replace the construction loan with a permanent loan prior to the end of the construction loan term.

5. Interest Rate: Lenders traditionally provide construction loans on a floating or variable rate, interest-only basis at the current prime rate plus some additional spread such as 1 to 2 percent. In recent years, some regional lenders have offered construction loans at the current LIBOR (London Inter-Bank Overnight Rate).

Floating- or variable-rate loans typically adjust up or down each month depending on interest-rate market changes. Be sure your pro-forma and economic analysis account for the effect of an increasing interest rate in today’s environment. At current market rates, project your construction loan interest rate between 7.5 and 10 percent, with potential increases as construction progresses.

6. Borrower Information: Include borrowers’ resumes and personal financial statements. Resumes should focus on each individual’s real estate and self-storage expertise and experience. Experienced self-storage investors can mitigate many risks a lender may identify. Construction loans typically require full recourse (personal guarantees on the loan) to the owners of the borrowing entity. Thus, the financial strength of the borrower is as important as the merits of the project itself.

7. Construction Company Background: Hire an experienced, reputable construction company with previous self-storage experience, ensuring the contractor is willing to work with your bank and the lender’s construction draw process. Include documentation about the construction company with your loan request.

8. Management Group: Always have a clear facility-management plan. If you expect to hire a third-party management firm, include its experience in the loan-summary package. An outside management firm is desirable because it gives lenders confidence that those running daily operations have sufficient experience, thus mitigating major risks. If you plan to manage the facility yourself, include a resume of expertise, experience and education.

Final Steps

Once you’ve assembled the loan package, it’s time to obtain quotes either from a lender or mortgage broker. Interested sources will ask to review your loan package, a credit officer will contact you with questions, and a term sheet will be issued detailing the proposed loan’s structure. Before executing the term sheet, negotiate the final loan terms to your best advantage.

Next, the lender will perform an extensive and detailed property analysis, with a third-party appraisal of the stabilized property value and an environmental assessment to rule out existing liabilities. The proposed loan is then sent to a loan committee for review; if approved, the closing process (title and legal work) begins. After submitting your loan package, expect funding to take 45 to 90 days.

Obtaining a properly structured self-storage construction loan takes time and effort, but you’ll build your facility with confidence knowing financing is specifically suited to your unique property needs. 

Devin S. Huber is vice president of Beacon Realty Capital Inc., a Chicago-based financial-services firm that arranges financing for all types of commercial real estate and specializes in self-storage financing nationwide. The late Richard M. Kerwin served as senior vice president of Beacon (for related story, see page 10). Mr. Huber may be reached at 312.207.8232; dhuber@beaconrealtycapital.com