Financing and Loan Types

Eric Snyder Comments
Posted in Articles, Finance
Print

Watching the economy during the past year has been like riding a roller coaster. The unemployment rate is up, corporate earnings are down, inventories are up and interest rates are down. So with all the talk from recession to recovery and hard landing to soft landing, how is the self- storage market performing? It appears to be holding up amid the sluggish economy. Most facilities are enjoying increasing rental rates--albeit at a slower pace than in past years. Nationwide, the number of new developments within the past 12 months has not outpaced demand.

Some owners believe the self-storage industry is recession-proof. The theory is when the economy is growing, people will consume goods and businesses will increase their inventories. When the economy slows, people downsize their homes and businesses and relocate their goods and supplies to less-expensive self-storage space.

Dissenters from this theory say the concept of a recession-proof business is unrealistic, and there are already pockets of overbuilding emerging in some markets. It may be true that self-storage operators with substantial experience and stabilized facilities will withstand an economic downturn better than their commercial real estate counterparts. However, a sluggish economy makes it more difficult for operators of stabilized facilities to raise rents and operators of new facilities to lease up. This is apparent in some markets where new facilities have reached 70 percent to 80 percent occupancy and are struggling to inch higher.

Does the uncertainty of the economy lead to volatility in the financial markets? The answer is yes. Though most lenders are still active, they are carefully monitoring the real estate markets to see if they will follow the declining trends that have plagued corporate earnings. This uncertainty is evident in a trend toward more conservative underwriting from real estate lenders. However, since most lenders during the 1990s resisted the temptation to initiate the aggressive lending programs prevalent in the 1980s, overbuilding has been kept to a minimum.

For example, most lenders in the '90s were reluctant to fund much above 75 percent loan-to-cost on new self-storage developments, even though 100 percent loan-to-cost loans were available in the '80s. This restraint has allowed lenders to tighten their lending policies rather than eliminate them completely. But we are still waiting to see how self-storage lenders will respond if the economy continues to be sluggish. Furthermore, most lenders do not understand the fundamentals of the self-storage business and are more likely to eliminate loan programs for this product if the economy heads toward recession. Those lenders who do understand the self-storage business are still susceptible to the performance of other types of commercial real estate in their portfolios. If a lender is accounting for losses on his commercial real estate loans, he is less likely to aggressively pursue new self-storage loans.

Weigh Your Options

In today's economy, you must evaluate all of your financing options. It is important to align yourself with a realty-capital advisor who can help you navigate through the uncertain times ahead. There is currently a trend toward consolidation, which means the bank or finance company you relied on for financing may not be around in the future. There are other companies that have decided to stop financing self-storage projects altogether and one or two that have filed for bankruptcy. In light of these uncertainties, it is more important than ever to seek the services of an advisor who can help you identify the best debt or equity player for your particular situation. An advisor can help you identify the most appropriate source of financing--whether it is from a commercial bank, credit company, life-insurance company, pension fund, private financial institution, investment bank or savings and loan.

The good news is, once you find a competitive self-storage lender and successfully complete the due-diligence process, you should be able to secure some of the lowest interest rates in history. Many variable-rate loans will be priced over LIBOR or prime, both of which are at historically low levels and have dropped by 3 percent over the past 12 months. For example, as of this writing, the prime rate has fallen from 9.5 percent to 6.5 percent, and the three-month LIBOR has fallen from approximately 6.5 percent to 3.5 percent over the past 12 months. (LIBOR, or the London Inter Bank Offering Rate, is an average of the interest rate on dollar-denominated deposits, also known as Eurodollars, traded among banks in London.)When lenders add their margins to these indices, it equates to variable-rate loans in the high 6 percent to high 7 percent range. The fixed-rate lending market is just as favorable. Many of the fixed-rate loans today are priced over 10-year U.S. Treasuries that have decreased by almost 2 percent over the past 18 months. With the additional margins added on to the 10-year Treasury, it is possible to obtain fixed-rate loans in the low 7 percent range for 10 years.

Finally, due to the fact that interest rates are at historical lows, you should be closely scrutinizing your financing alternatives in today's market. What are your financing options as they relate to construction loans, bridge loans and permanent loans?

Construction Loans

The interest rate for a construction loan today is lower than what most of us pay on our credit cards. The majority of construction loans are provided by commercial banks for owners developing a new facility or expanding an existing one. Typically, banks with which you already have a working relationship offer the most aggressive loans. The banks will place an enormous importance on your experience, track record and results of a feasibility analysis.

These loans are full recourse, and the lender will need to scrutinize your personal financial statement to determine if you meet its net-worth and liquidity requirements. The lender will completely analyze your pro-forma statements including your projections of rental income, vacancy, months to lease up, expense ratios, etc. All of your projections will be compared to the market, and you must justify the use of projections that are more aggressive than the market. Additionally, your costs to construct the facility will be compared to those of other facilities recently constructed in the market.

Once all the lending requirements have been met, you can expect to receive some very competitive pricing, since most construction lenders will provide variable-rate loans based on LIBOR or prime. Your overall interest rate can be anywhere from 7 percent to 8 percent for a loan that provides 75 percent loan-to-cost.

For owners whose banking relationships have been disrupted, I recommend seeking the assistance of a realty-capital advisor to secure a new relationship. A larger institution may have acquired your bank or your loan officer may have moved on to other opportunities. As a result of the industry consolidation, there are smaller banks looking to develop relationships and provide competitive loans for self-storage developments. Many of these banks look to realty-capital advisors to bring them new clients since they are not sufficiently staffed to directly originate.

Bridge Loans

A bridge loan is usually a short-term, variable-rate loan used to replace a construction loan prior to the property achieving full stabilization. This may be necessary because the construction loan was for 18 months and the property is not fully leased at the end of that term, or merely to replace the construction loan with one that has a lower interest rate or is non-recourse. A bridge loan can also make sense when an owner acquires a facility that was poorly managed or collecting below-market rents.

The bridge loan will provide the owner a short term (three to five years) to reposition the property and pay only a minimal prepayment penalty to pay off the loan. The property is then normally sold for a profit or the loan is paid off with a long-term, permanent, fixed-rate loan. Many bridge loans are non-recourse and priced over LIBOR. The LIBOR pricing allows loans to be funded with overall interest rates--today in the high 6 percent to low 7 percent range. It should be noted that most of these loans will have a floor interest rate to ensure a minimum return for the lender.

The most important aspect of these loans is their flexibility. If you are leasing up a facility or repositioning it, you can receive additional funds in "earn-outs" as you increase the property's income. Another difference between a bridge loan and a construction loan is if a facility is seasoned enough, the lender will go from 75 percent loan-to-cost to 75 percent loan-to-value, which can equate to significantly more loan dollars.

Permanent Loans

The intent of a permanent loan is to capitalize on low, long-term, fixed interest rates. At the time of this writing, you can secure a fixed rate in the low 7 percent range for 10 years. However, due to the restrictive nature of the prepayment penalties on these loans, your business plan should involve keeping the facility for the entire length of the loan term. Additionally, this loan should be obtained once you have fully stabilized the property and determined you do not wish to pull additional equity out of the property for the length of the loan term.

A unique feature of most permanent loans is you can pull equity out of the property. For example, if you spent $1.5 million in construction costs to develop a facility and it is worth $3 million in three years, you would qualify for a $2.25 million loan at 75 percent loan-to-value. The difference of $750,000 between the permanent loan amount and the original construction cost is your profit. You do not have to reinvest the profit back into the existing facility.

Since most of these loans are based on the performance of the actual property, they are non-recourse and, therefore, your net worth and relationship with the lender are less important. The lender is concerned with the historical operating numbers, asset quality and market dynamics in making a lending decision. Although your experience, net worth and credit history are weighted, the key to getting the lowest fixed rate in the market is keeping good historical records on the performance of your facility.

Most permanent lenders will scrutinize your historical operating statements and compare them to other facilities in the market. If you keep good records, the lender will be able to give you credit when you are managing the facility better than your competitors. However, they will still default to some industry standards even if you can prove your facility has lower expenses. For example, most permanent lenders will underwrite to a minimum vacancy of 10 percent and a minimum management fee of 6 percent.

There are also two different types of permanent lenders in the market--one is a portfolio lender and the other is a commercial mortgage-backed securities (CMBS) lender. A portfolio lender will keep the loan on its books during the course of the loan term. The benefit to this type of loan is its flexibility with the ownership structure, prepayment penalty, loan term and in-house servicing. The negative to this type of loan is the fixed interest rate is usually .5 percent to 1 percent higher.

A CMBS loan, on the other hand, will allow you to receive 75 percent loan-to-value financing in the low 7 percent range for 10 years. However, for the reduced interest rate you will give up substantial flexibility in your loan terms. For example, you will be required to form a single-purpose entity as the ownership structure of the facility; you will have very restrictive prepayment penalties in the form of yield maintenance or defeasance; and you will be required to escrow funds for real estate taxes, insurance and capital improvements. If your intent is to hold on to the property for the long-term, this may be your best option to lock in historically low, fixed interest rates.

Now is the time to examine your business plan and determine if you are paying too much for your proposed or current financing and/or if your financing matches up with your investment strategy. The current economic environment is somewhat unsettling; but if you have an existing facility or new development with an excellent feasibility study, now is the time to lock in financing. There are still a number of lenders aggressively investing their money into self-storage projects, and with rates being so low, now may be the best time to grow your business.

Eric Snyder is a vice president with Buchanan Street Partners, a West Coast-based real estate investment bank. The firm makes principal investments on behalf of its private and institutional clients through The Buchanan Funds while also providing realty-capital advisory services to owners and developers. Mr. Snyder can be reached at 949.219.1201.

Comments
comments powered by Disqus