By Tara Collins
Higher interest rates have slowed the progress of smaller self-storage financing transactions. However, most lenders say there's still plenty of cash to go around and creative deals to be made.
Acquisition and development money can come from several sources. Wall Street firms provide institutional dollars. Banks and credit companies provide traditional financing. Mortgage companies and brokers can round out financial options by offering nontraditional sources as well. Real-estate investment bankers can go to bat to solicit needed funds for development, acquisitions and mergers.
We spoke with several key players in the financing industry, asking them to share their views on the market, lending terms, interest rates, the state of the industry and more. Check out what the insiders have to say about the marketplace, preparedness and financing beyond 2000.
The Upheaval of 1999
Despite increases in Treasury bonds and interest rates, lenders are eager to lend. That's good news for owners and developers. The bad news is higher interest rates crunch the total dollar amount borrowers can receive while elevating cap rates and squashing the asking price a seller is garnering. "There has been a lot of talk by Greenspan and the Feds that they're going to raise rates, but Treasuries will react before rates are even raised," points out Eric Snyder, director at Irvine, Calif.-based FINOVA Realty Capital. "Recently, Treasuries have gone up at least 70 basis points (BP) in the last 60 days. As you see Treasuries go up 70 BP, a fixed-rate loan that was at 7 percent 12 months ago nowadays runs 8.75 percent to 9 percent."
David Smyle, president at La Mesa, Calif.-based Benchmark Financial, also blames Treasuries for higher interest rates. "The 10-year benchmark is hovering around 6.7 percent, up approximately 2 percent since 1999. Speculation is for rates to stabilize, but probably not to the levels we saw in 1998 and early 1999. There are a number of treasuries out there that lenders can pick and choose to quote from. The most common is the benchmark, or 'on the run,' Treasury. When a lender quotes a 10-year Treasury, it's important for the borrower to ask the lender to identify which Treasury he is using. They could be quoting another month's Treasury. Treasury auctions come out several times during the year: February, May and November. So, if you're quoting the 'on the run,' you are quoting the most recently issued, what price it is trading for today."
Rocketing Rates Impact Lending Practice
Rising rates ultimately affect debt-coverage ratio (DCR), loan-to-value (LTV), borrower willingness and investor perception. According to Michael McCune, president of Argus Self Storage Sales Network in Denver, "In addition to the Fed's moves, investors are beginning to think there may be some new inflation coming. To get the interest rate that would be applicable for a 25-year self-storage mortgage, you would add about 2.5 percent to the then current Treasury rate--or significantly more than 9 percent today. This add on, called a "spread" in the business, is to recognize that a self-storage loan is riskier than a government bond."
Shrinking spreads and rising rates make it harder for lenders to meet a borrower's request. The difficulty in underwriting is attributed to the standard 1.30 DCR. "This will require some lenders to go down to a 1.25 DCR to get the dollars out or provide earn-out scenarios allowing borrowers' to achieve their financing goals," explains Benchmark's Smyle. "We may also see 30-year amortizations on newer properties in an attempt to meet the DCR requirements.
"DCRs are a function of the loan amount requested, the interest rate being charged and the amortization. With a higher interest rate, your annual debt payment goes up and the DCR is a calculation of the project's net-operating income divided by the annual debt payment. So, the higher the debt payment, the lower the DCR is going to be. As the DCR becomes lower than 1.30, lenders start cutting the dollars down so they can meet that DCR."
As a result, Snyder sees FINOVA cutting back on its underwriting. "We're requiring borrowers to meet the 1.25 DCR and an 80 percent LTV. You'll find that most of the market is now moving the DCR from 1.25 up to 1.30 and the LTV's down from 80 percent to 75 percent. It's becoming more stringent in terms of the way we're underwriting them, and borrowers can't get the same amount of dollars that they're used to getting. In the past, we would take the last three to six months of income, annualize it to determine the project's total revenues, and then lend off of that. Now we're sticking to a trailing 12 months, even if the property is relatively new. Most borrowers who could get fixed-rate financing prior to stabilization now have to wait until their facility is completely stabilized for 12 months before they can even come to a permanent lender."
The Changing Face of Financing
Neal Gussis, senior vice president of Chicago-based First Security Commercial Mortgage, sees the demand for financing as filling a "need" vs. refinancing. "Most financing deals today are either for acquisitions, properties that are rolling out of construction financing, or properties that have loans maturing in the next year," he says.
Currently, self-storage spreads vary from 160 BP to 250 BP for loans over $1 million depending on loan size, and DCRs and LTVs resulting in overall rates in the 8.3 percent to 9.2 percent range for the typical 10-year term with 25-year amortization. "Gone are the days of the sub-8 percent fixed rates, although adjustables can be found in the high 7 percent to low 8 percent range," notes Gussis. "Loans under $1 million can expect to pay fixed rates above 9 percent."
Snyder at FINOVA feels the lending climate is favorable but not superb. "Most lenders will do self-storage; they aren't backing out, but are more cautious in their underwriting. What we used to do were 'earn outs,' where you would get one or two additional fundings after your initial funding. Most permanent lenders would fund the loan and then securitize it in the CMBS market. In the past, we held the loan and took the risk until we funded an earn out because the CMBS markets were relatively stable. But now, they have gone all over the board. Treasuries and spreads go up, CMBSs go up; the risk is too significant. Most lenders have said they'll only provide one funding."
As a result, Gussis sees sources becoming more diverse. "Many, but not all, of the national conduit lenders are less interested in deals less than $2 million. This industry has an enormous number of properties that fall under this category. The good news is many of the local banking institutions have shown desire to lend for these smaller loans. The industry is going through change and consolidation. Conduit lenders who have traditionally offered long-term fixed rates are facing additional pressures because now owners are also considering shorter term deals and/or variable-rate deals."
Variable-rate loans are the hot ticket for 2000. "We'll still provide a fixed rate, as well as a floating rate," notes Snyder. "But we're adapting to the new interest-rate environment. We have also looked at self-storage more cautiously as a product. For the most part, it's a recession-proof product. As lenders, we're not too concerned if the economy is strong. In good times, people are storing their toys and spending money. In down times, companies are downsizing, people are moving into smaller homes, so there is always a need for self-storage. Our biggest concern is overbuilding. The first thing our analysts do on a loan request is call the planning department of the respective city and ask if they have any new facilities planned to come on line or are currently expanding. Fifty percent of every deal has something coming online in their market."
What to Look for in a Financing Provider
Industry Knowledge: According to Eric Snyder of FINOVA Realty Capital, "Find out what experience the lender has in self-storage. A lender without experience in self-storage may not give the borrower full credit for the facility's earning potential. As a typical example, many facilities operate with a collection of late charges on a monthly basis. A less experienced lender would not give the borrower credit for that income. Also, there are truck rentals and month-to-month leases that may give a borrower difficulties when trying to explain this to the lender. Lenders should know the business at hand."
Flexibility: "If a developer has exhausted his search for construction financing from his local institutions, he may want the help of a local/regional firm experienced in placing commercial construction loans," says David Smyle of Benchmark Financial. "Using a brokerage firm usually costs the developer an extra 1 percent to 1.5 percent in construction-loan origination fees. But if the firm gets the job done, it will be worth it."
Experience: Kevin Gannon at Robert Stanger & Co. says to never underestimate past performance. "Look for a company with a track record of performing on transactions similar to what you are trying to accomplish. Be it consolidating and creating a public company or obtaining financing at the entity level to consolidate your holdings and provide financing, you need someone who has done it before."
Finding big money lies on a platform of assets, according to Kevin Gannon, managing director at Robert A. Stanger & Co. in Shrewsbury, N.J. "You need assets under management, and more is better; $50 million is a good base to start raising outside capital. No one really wants to talk to you unless they can spend $20 million to $30 million. If you only have $10 million in assets, you don't have enough management infrastructure to support a larger business. The cost of your management is burdensome. You need so many people on staff to manage three properties or 30. It's better to spread it out over a larger portfolio."
Brad Stoesser, analyst for Morgan Stanley Dean Witter's U.S. Real Estate Securities Fund (MSDW), says big money is out there. Stoesser's fund will allocate 4 percent to 5 percent of its portfolio to self-storage in 2000, roughly $77 million. "As a fund for institutional investors, we invest strictly in stocks. We deal primarily with the four public REITs (Public Storage, Shurgard, SUS, and Sovran). These REITs, with assets over $100 million, are getting higher yields and better returns off developments because the acquisition market is deemed to be apparently tight right now."
Looking for big money provides opportunities for firms like Robert A. Stanger to serve as matchmaker. "In the past year, we've raised capital for entities looking to expand their business," says Gannon. "Many of the self-storage REITs are trading at good discounts in excess of 15 percent. One reason this may have occurred is because the market was overheated and corrected itself. As a result, a bit of disappointment set in with investors. Alternative investments like tech stocks were skyrocketing. Hot capital rushed over there, leaving real estate a bit on the cool side."
Argus' McCune sees higher interest rates providing REIT investors with a thin silver lining. "There may be some potential benefit from all the recent gyrations in the stock market. While the impact of rising interest rates on asset values is fact, all of what follows may just be gross speculation, and we will just have to 'hide and watch' to see what really happens. With the pressure on the high-flying tech stocks, there may be some renewed interest in the high dividends paid by the REITs. This might allow the REITs to get back into the stock market and buy some additional units. However, even if this does happen, the interest rates will continue to impact the pricing of facilities."
Five Things to Avoid When Asking For Money
1. Don't lie. "Be honest and upfront," says Snyder. "Whatever the property's history, it will surface prior to loan closing. If we know about it upfront, we can work with the borrowers to remedy it."
2. Don't be forced into any deal you aren't comfortable with. "As with any business transaction, deal with people that you feel have the ability to support your transaction," says Gussis. "Feel comfortable that your lender contact is going to be able to support you and your transaction through the process."
3. Ask and answer questions. "Experienced mortgage professionals should be able to give you all the particulars of a loan program," notes Smyle. "They should be asking you questions to prompt your thought process about issues you may not realize are important. Your mortgage professional should represent you as your agent, and have no outside influences such as spiffs, servicing fees or prizes awarded based on volume with a lender. In reality, an experienced mortgage firm should narrow their search down to five or six best lenders after finding out your particular needs from the initial interview."
4. Be a Boy Scout. "Be prepared to present yourself in a well thought-out plan. Address the use and deployment of capital," says Gannon. "Demonstrate an exit strategy over a period of time. Ordinarily, this new money is going to want an exit strategy. That may be to form a public company if the market conditions permit. It may be a sale of the assets or a merger with an existing entity. You have to be prepared to discuss and cede that control to the new investor. If in four to five years, you don't have public market, you have to be prepared to sell the assets. If that's what it takes to get the new money a return on its investment, be prepared to cash out."
Sticking With Friends
Many companies are taking the initiative by aligning their allies, combining portfolios with unlikely asset classes. The new trick is balancing money opportunities through joint ventures and creative stock options, which produce stabilized incomes and black bottom lines.
Stanger's Gannon attributes these creative dealings to public market volatility. "I think what happened was that the returns weren't up to par last year. The capital continued to dribble out of REITs overall, and now they are trading at heavy attractive discounts from the buyer's perspective. The bad news is that event makes capital formation at the public level more difficult. So the UPREIT-type transactions and equity raises done previously can't be done any longer--they're just too dilutive. You wouldn't sell interest in your company at a 30 percent discount, but you would sell it if it were at a real fair value or higher price. So companies are forming joint ventures with institutions to do development projects. We're seeing more patient money doing off-balance sheet development activity."
And wheel and deal they are. "Some companies are doing interesting deals to get a higher yield on their development," notes MSDW's Stoesser. "Some of them are having funding issues as far as raising capital; they can't do it through the equity markets, so they are splitting it with a JV partner. For example, SUS just sold off several properties to Fidelity and retained a portion of that--25 percent or so. Now they can utilize that count roll for other things, to go buy a few properties or develop more.
"Similarly, Public Storage is issuing a pseudo-common stock. It's not common, but it's like an equity stock, just not preferred. Initially available only to shareholders, they are issuing these to raise more capital. At year-end, they gave shareholders the option to take distributions as stock at 65 cents per share or take it at cash at 62 to 63 cents a share."
The self-storage asset class was legitimized in the '90s. "Prior to that, it was considered an 'also-ran' asset class," adds Gannon. "Institutions didn't pay much attention to the industry. They waited to see how this business panned out. Then the Shurgards and U-Hauls of the world showed up; the industry started to consolidate. New players came on the scene like Storage USA, Storage Trust, Sovran. Now you have players out there that have legitimized the industry.
"Last year, we did the Devon transaction, which involved one of the Goldman Sachs affiliated Whitehall Funds, putting $100 million into Devon's new-development activities. People aren't generally rolling up their assets and forming a REIT. They are looking for institutional partners to provide financing in addition to bank financing."
Come For Dinner
"Bring good records," chides Snyder. "We'll look at cash flow three years back; we want to mark the trends. By keeping good records and explaining where the money goes (like capital improvements or non-property related expenses), borrowers can help us get to a higher NOI on the property which means a higher loan value."
Gussis suggests learning from the past. "But don't live in it. The future is yours. If you are seeking financing today, see if the economics of a financing transaction supports your short and long-term earning objectives. If your earning objectives are obtainable today, you should finance today. The driving force will be finding a lender that can match your financing desires. "
Smyle agrees with the idea of knowing what you're looking for. "Parameters such as recourse, prepayment penalty, term and loan costs are important to many borrowers. Is interest calculated on a 360 or 365 day basis? The 365-day basis can add nine to 10 BP to your effective interest rate when comparing against 360-day quotes. How long will you keep the property? Loan prepayment may subject you to stiff penalties upon payoff or may restrict your ability to finance additional construction to the property. Most lenders do not want to be in a second mortgage position. Meanwhile, borrowers may be willing to pay more costs or put up with full impounds to get the program of their choice.
Stoesser believes in developing market concentration. "In general, if people want to eventually get institutional investors, they need to continue to grow. Also, they need to focus, build up a base and develop market concentration, as opposed to having a store here, a store there. Market concentration brings higher returns. When one property fills up, you can defer customers to your other property that's three to five miles away."
Gannon believes you need to bring a plan to the table. "What are you going to do? Expand the existing facilities in your portfolio. Develop additional facilities. Option some land to develop. Acquire in-fill properties in the area where you already are established. If you're in Ohio and you have properties in Cincinnati and Cleveland, maybe there are outlying properties to acquire so your cost of management doesn't change. Having land for development in a good location is a good sign that you have a good place to put the capital."
For Gussis, success in obtaining financing comes down to two words: what if. "Ask 'What if?' in your business strategy," he suggests. "Each 'what if' has a relative weighting or probability. Pose both positive and negative forces that may affect you achieving your monetary objectives. Every person has a relative risk tolerance. After your analysis, if it makes sense today to finance, then you should proceed and start talking to lenders. Bottom line: In most instances, money is still available at reasonable terms and rates."
Benchmark's Smyle is also optimistic. "There is plenty of money to go around, but competition will be stiff. I believe we will see the marketplace for borrowers broaden with the addition of more banks, S&Ls, thrifts, and even credit unions in some parts of the country making inroads against the traditional conduit (Wall Street) lenders. These lenders will offer lower adjustable rates and shorter term fixed-rate products with prepayment flexibility and lower costs in order to compete. On top-quality, stabilized properties, insurance-company money may also be available at the lowest rates and more flexible terms."
On the other hand, McCune sees growth coming from education. "People are still learning to use our product. Only about 5 percent to 6 percent of the population has ever used self-storage. Thus, unlike apartments or offices, we don't need live bodies to populate our product--just more junk. If just one percent more of the population learns about and uses self-storage, our potential market grows by 20 percent. No other kind of real estate can make that claim. Having an investment community knowledgeable about the potential of our industry will raise our values and liquidity."
Tara Collins is a freelance writer working out of Red Bank, N.J.
Neal Gussis, Senior Vice President
David Smyle, President
Bradford Stoesser, Analyst
Kevin T. Gannon, Managing Director
Eric Snyder, Director
Michael Kidd, Executive Director
Michael L. McCune, President