By Tara Collins
Though reserved, lenders and Wall Streeters are optimistic for 1999. While the market took a hard turn during the last two quarters, things are beginning to look up for self-storage owners seeking debt and equity. Most sources agree that interest rates will remain at current levels; however, potential borrowers can better their chances by improving their own standards, and if the money doesn't flow from traditional sources, a look at financing alternatives can often fill a fiduciary need.
Capital Markets Impact
"As you know, the market has slowed down, particularly in the last quarter, due to the volatility of Wall Street," observes Neal Gussis, senior vice president at First Security Commercial Mortgage in Chicago. "The downturn was attributed to bond market investors and their flight to quality or safety. Shying away from corporate bonds and commercial mortgage-backed securities (CMBS), people were investing in safer things such as U.S. Treasuries. The upward swing in 1999 can be attributed to a higher confidence level. Investors have come back. We're back in a time period when the economy is very good. Yet, there are economic factors that could still cause volatility. But the financing companies backing the market have taken measures not to be caught off guard as they were last year," Gussis explains.
The outlook is good. But pricing has increased. Spreads over Treasuries have gone up. There are less players willing to loan money. But the consensus is there's still a lot of capital out there.
Michael Sneden, executive vice president/head of origination at New York-based ValuExpress says he looks forward to a productive year. "Essentially, the capital markets recovered faster than anyone ever imagined. Lending in the self-storage area, as well as the other asset classes, has come back quickly and almost to the level of aggressiveness as mid-year last year. I think 1999 will be a good year for permanent loans on self-storage facilities," Sneden says.
A bit more skeptical is Ray Wilson, president of CRW Associates, an appraisal firm in Pasadena, Calif. "My general perception is that the markets are still doing very well," he says. "Last summer, the CMBS market came to a screeching halt because bond buyers moved out. Now that's turning around. Bond buyers are coming back into the market again, albeit at higher rates than offered in the last 14 months. However, borrowers are a bit apprehensive, holding back, waiting until the rates come back down. The question is, will the rates come down? The lenders say they probably will not. The borrowers are thinking, 'Well, if the lenders have a lot of money and product is available to loan on, eventually the rates will come down.' But it's really anybody's guess."
Some argue that borrowers have gotten spoiled by the low-interest-rate availability. "Interest rates aren't really all that high," continues Wilson. "They are reasonable compared to most real-estate loans today, particularly compared with what was available in self-storage up to about 18 months ago, before the rates got too low."
As for Wall Street, it's just a matter of time before money becomes available for self-storage owners. Bradford Stoesser, analyst at Morgan Stanley Dean Witter (MSDW) in New York, thinks borrowers will have to wait and see how the market reacts in the next quarter. "Currently, we are not doing self-storage deals. That's mostly due to the market's current status. Obviously business is good and the value of companies is coming back in line with stock prices. But, we'll have to see how things play out in the next two months," Stoesser says. "Because self-storage tends to be development intensive, it is usually one of the later sectors to receive financing."
Many lenders and bankers are eager to generate new business in 1999. Some are tailoring programs to meet the needs of large and small operators. "I think more people will realize that self-storage is a good property type to be lending on," says Cheri Grossman, senior vice president and manager, small loan program, at Heller Financial--New York. "We provide fixed-rated financing for stabilized properties, permanent 10-year loans with 75 percent loan-to-value. Our loans, generally for refinancing and acquisitions, start at $500,000 with no upper limit."
On the other hand, ValuExpress is a conduit lender. Self-storage is approximately 5 percent to 10 percent of their overall lending business. "We lent out about $5 million last year to self-storage owners," notes Sneden. "Generally, we do one-property deals. We channel our self-storage business through two small loan programs supporting deals in the $250,000 to $2 million range, typical of the self-storage universe.
"Our first program has lower upfront fees to cover reports such as engineering, appraisal and environmental. Initial fees for this small-loan program including lender's legal costs, about $5,000. Borrowers pay a slightly higher interest rate, about a quarter point higher than the other program, where we get more detailed pre-closing reports. Total upfront fees here cost about $7,500 to $10,000. The interest rate is lower, currently running at about 8.5 percent," outlines Sneden.
ValuExpress has tried to meet the demands of the market and offers a few construction loans in conjunction with banks, usually following up with permanent loans upon lease-up. But, 98 percent of the lender's business is straight permanent loans through Wall Street. "We will go up to 80 percent of the purchase price," adds Sneden. "We pride ourselves on speed and service. Many people who want to buy or revamp their properties wouldn't go to a conduit because they think they can't get a loan fast enough to meet their contract requirements. Up to $2 million, we have streamlined our application process, making it easier to get the acquisition loans closed within 60 days."
At First Security, 1998 outpaced the same volume of loans it did in the two previous years, which was about 60 deals annually. "We primarily offer permanent financing loans for acquisitions. Most borrowers are choosing between two different types of loans," explains Gussis. "The 10-year term with a 25-year amortization provides borrowers good cash flow on a monthly basis. After 10 years, a bullet or balloon is due. So, the operator goes back to the well to refinance or pay off the note. The other borrowing philosophy is the 15-year fully amortizing loan. This approach pays off the loan over 15 years and provides the borrower with a good investment vehicle. It's more like a 401K investment, whereby after 15 years, you have an asset that is fully paid for. Which loan a borrower adopts depends on the borrower's investment strategy. People who lean towards selling the property tend to go for the 10 to 25."
Alternatives to Financing
Whether an operator is looking to exit the market or expand his portfolio, he can exercise a few options. "At First Security, we do offer alternatives to financing on a deal by deal basis," adds Gussis. "For example, we have access to nonconduit funds or non-Wall Street funds for shorter term loan with more flexible pre-payment provisions."
Financing alternatives also include 1031 tax-deferred exchanges, property swaps for operating partnership units, equity fundraising and public/private placements. The 1031 is a stepping stone into and out of the self-storage industry. Kevin Gannon, managing director at Robert A. Stanger & Co., an investment banking firm in Shrewsbury, N.J., looks at this scenario to make a point. "Assume, for example, you are elderly and you want to exit the business. The property's too much work for you. But you don't want to take the capital gain for the property. You find a buyer who wants to swap. It's a one-for-one trade: your $5-million self-storage facility for his $5 million, triple-net lease property (or any other property type).
"This transfer provides you with two advantages. First, you get out of the operating demands. Second, the new property type allows you to get a more assured income stream. Instead of going to manage a property everyday, you clip coupons from an AA/A credit on a tax-deferred basis. Here you collect a 9 percent to 10 percent yield on your property value for 10 to 20 years. The downside is that you're in an illiquid property. You can find a buyer later, but this approach may not be as lucrative as putting your money in stocks. The alternative is to sell the storage property outright for cash, take the taxable gain, pay the taxes, be left with roughly 70 cents on the dollar, and reinvest that money in the stock market."
A second option to selling out is exchanging the property for operating partnership (OP) units. "Today, there are fewer willing buyers on the OP units side," says Gannon, "because OP units were crushed in terms of value in the past six to eight months. However, there are a few out there who still have pretty healthy appetites. The OP unit downside is they are originally illiquid assets. You convert them later into stocks, usually one to two years down the road. However, once you turn the stocks in for cash, it becomes a taxable event for you, and you pay taxes. The other advantage to this approach is that you may be able to borrow against it. For example, if you have $5 million in OP units, you may be able to borrow $2 million to $3 million cash tax-free against a loan secured by your units."
A third alternative to financing is equity fundraising. Here an investment banker works on an operator's behalf to solicit funds from public, private or pension investors. In July 1998, Stanger assisted Devon Capital Management in raising $100 million. Devon had $100 million worth of assets under management and wanted to expand its portfolio without incurring the burden of loans and interest.
"You have to have some size to do this type of deal," warns Gannon. "It would be hard to do a $20 or $30 million equity fundraising; it takes just as much time and energy to raise $100 million." While the terms of the Devon deal are proprietary, Stanger basically organized a business plan with specific objectives and solicited potential investors for the deal. A match was made with a private investor, allowing Devon to conduct expansion under its own terms. Hence, Devon is able to buy appropriately fitting properties without the time constraints of securing a loan and the overtones of loan payments and interest. "The disadvantage to equity fundraising is that you spread your risk a bit," notes Gannon. "But the advantage is that you access capital now to grow more quickly. Taking advantage of promising marketplace opportunities more than offsets the cost of having a new partner, i.e., sharing the upside with somebody."
Lastly, as Wall Street comes around, investors should be ready to handle the demand. "On MSDW's investment management side, we invest directly in the stock of the company itself," notes Stoesser, "holding those stocks in our portfolio in either a general account or a client-specific account. Our core group invests in real-estate securities in a fund, so the companies we deal with are public. MSDW doesn't leverage a deal like in a loan. We exchange cash for stock and then sell the stocks when appropriate. Our Special Situations group deals with private sector while our banking side raises the capital for IPO deals."
Be Prepared, Be Qualified
Lenders and investors alike are concerned with a facility's operating history, stabilized occupancy and location. At ValuExpress, mortgages are almost entirely based on the cash flow of the property. Says Sneden, "We look at the property's last three years' operating statements. We're concerned with the income produced by the assets. The personal credit of the sponsor is secondary. These are nonrecourse mortgages; the sponsor or individual does not personally guarantee the loan. Instead, we secure the properties as collateral."
First Security's Gussis agrees. "We offer nonrecourse loans with standard exceptions, which means we look to the strength of the property. We look at the stable supporting, historical net operating income (NOI). The debt service coverage is generally 1.30 or better today. That means a borrower should have at least 30 percent more NOI than the debt service or loan payments on an annual basis."
MSDW looks for high occupancy rates. "We look for potential inside value like low rents with upside." says Stoesser. "Facilities should possess good location, both geographically nationally and within the city itself. One consideration is urban areas. They tend to have higher rents and occupancy. They turn over quicker, tenants stay less time, and the rents are actually higher. In rural areas, there is a tendency for rates to decrease as the tenant stays longer."
Heller Financial looks to the operator's experience. "We like to see someone who has been in the business, the longer the better," Grossman points out. "A borrower's knowledge of the market impresses a lender. How well has he studied the market, its demographics, square footage per capita, income levels, etc.? Don't simply quote that the other self-storage facilities in the market are doing well. Look at what the bottom line can generate. Research your market and let your lender know you know what you're getting yourself into."
Lenders and investors are beginning to look at self-storage now as a stand-alone property. Years ago, it would be compared to retail or hotel analysis, or simply lumped into industrial. "Lenders are scrutinizing the product at a more sophisticated level than before," observes Michael Kidd, executive director of the Self Storage Association (SSA). "Wall Street is looking at this property type closer and with more intense analysis. Yet, a good transaction continues to entice the lender. They know what questions to ask about a market. Their first question will be, 'Is a market saturated, or does it have room to support a new facility?' Recessionary resistance is this product's key asset; self-storage is resilient in good and bad markets."
Kidd sees residential construction as an indicator to increased self-storage product and usage. More and more house movers and home purchasers are calculating self-storage costs into their move. The local self-storage facility is becoming an integral part of home buying. "I think you will see strong attention being given to conversions, renovations and modernizations vs. building a new facility from scratch," Kidd says. "Interest rates ultimately affect delivery of a product. Addressing the concerns of overbuilding will require more work and calculations of would-be borrowers when it comes to defining their project to a lender. Lenders want to see owners presenting a well-thought-out professional business plan."
"There is a perceived notion that self-storage has become overbuilt," continues Kidd. "Unfortunately, that concept was arrived at without the benefit of cumulative statistics. Data is not readily available as other individual property types because it is often lumped together with other industrial portfolio statistics, such as retail. While some markets are overbuilt, not all markets are totally saturated. It would be unfair to assume that all markets are closed. While it's hard to get a nationwide occupancy figure, self-storage facilities are running at 85 percent to 90 percent occupancy nationwide," says Kidd. "Other property types envy that level."
Heller's Grossman is not as optimistic. "My impression of the industry right now is that there is a lot of inexperienced people who see bottom-line cash flow and find this very intriguing. The costs to build aren't that large, and people think it is easy to get into this business. They see a profit to be made. But in essence, they don't have any experience to run this type of business. So, I'm a bit concerned about overbuilding, of under-experienced operators getting into the business. This may hurt the industry and the top-notch operators. But then again it may provide opportunity for them as well. Once these people build, they may find it's not that easy to run a facility. These newly built facilities will eventually be brought to market as one-timers get out of the industry."
Searching the Horizon
Profitable sales prices reflect not only good properties on the auction block, but indicate buyers are paying premium dollars for professional management and property administration. The biggest news of 1998 was Public Storage acquiring Storage Trust. "What this impact will be on the industry is anyone's guess," notes SSA's Kidd. "I'd watch the pace of REIT acquisitions. Their movement often indicates a strong financing trend. I think additional consolidation will continue in the future, be it from large publics or smaller privates expanding their asset base. There was a slight decline in REIT acquisitions in 1998. But, there is no definite proof that sales-cost-per-square-foot was down. Hopefully, self-storage sales will follow the trend in the real-estate market, which should be up. But, don't let a decline fool you; it's still a seller's market in self-storage."
As for the buying market, activity is evident. "There are quite a few transfers going on," notes Wilson. His company appraised almost $2 billion in self-storage over the past 24 months. "Most properties are not being transferred at a loss," he explains. "But, the REITs have almost totally backed out of the market at this point. Many don't have any money right now to speak of. Last summer, because their stock underperformed, they backed out of the acquisition market all together. Acquisition prices just got too high. REITs were paying a premium over replacement costs."
While REITs continue to merge with each other, smaller owner/operators dabble in the acquisition market as well. "What I see are the funkier asset classes, like self-storage and hotels, benefiting from this situation," observes ValuExpress' Sneden. "The capital markets are providing tremendous opportunities for borrowers to lock in low interest rates, take cash out, and do whatever they want with it. By taking equity out of their projects, owners can continue doing other projects or make other investments. It's a great time for people to borrow in the self-storage area. Treasury rates are low and it's unclear how long they will stay there. So they should jump on the bandwagon while the opportunity is hot."
Robert A. Stanger & Co. (RASCO) is an investment banking firm specializing in fairness opinions, equity fundraising and property-portfolio sales. In the last four years, RASCO has assisted self-storage clients with assets totaling more than $2 billion. For more information, call (732) 389-3600.