With interest rates at record-low levels and a sagging economy, would this not be a great time for self-storage finance? One would certainly think the banks would jump at the chance to finance self-storage properties, given the low interest rates. Lower rates make it easier to qualify for a loan, correct? Lower rates mean the money costs the banks less, so they have more "profit," right?
Well, the news is not really so optimistic. Sure, lower rates mean your debt-service coverage is higher, so the loan is "stronger," but the story not told is one generated by fear and uncertainty. Bankers do not want to get caught with a low-interest-rate loan on the books, and when it comes time for you to qualify for a loan to pay them off, they want to make sure you will be able to qualify under "normal" lending conditions.
You have heard the political pundits speak of lowering interest rates to spark up the economy, but all it really does is put a fire under the feet of lenders to make better, more conservative loans--that usually means fewer loans pass muster, and the advances are at lower loan-to-values. Most borrowers are pursuing fixed-rate loans instead of variables when rates are as low as they are today.
Low Interest Rates Means Low Interest Rates, Right?
Low interest rates in the press (the lowering of the discount rate) means banks pay less for the money they borrow from the Fed. But in the real world--the self-storage borrowing world--it means some reduction in rates, but not in direct proportion to the Fed lowering the discount rate. Quite simply, if the Fed lowered the discount rate to 3 percent tomorrow, it would likely have little to no effect on your typical self-storage loan.
Since the commercial mortgage-backed securities (CMBS) collapse in September 1998, lenders have protected themselves with interest-rate floors so they do not get caught with loans on their books they cannot sell. That means that, generally, no matter what happens with discount rates, self-storage loan borrowers will still pay around 7.5 percent for loans--at a minimum. Short of a long explanation of securitization, lenders do not want to make loans in a low-interest-rate environment where when rates go back up--and they will go back up--they or conduits cannot sell the loans without losing money on the discount.
Is It Confusing Yet?
Let's use the following example. The numbers will not be accurate, but the concept is correct.
ABC Mortgage is arranging for a $2 million loan for Sam's Storage. The 5-year Treasury Index is at 4 percent. The interest rate or note rate ABC has provided is 6 percent. The loan is closed Nov. 1, and funded by Carl's Conduit. On Nov. 15, rates begin to rise very quickly, and by Christmas, the 5-year Treasury is at 8 percent. Sam is very happy! He got his loan closed before interest rates went up, and can now take $100,000 of the loan proceeds and buy a U.S. Treasury bill and make 2 percent just for being smart. Meanwhile, the stock market has regained all of its momentum, the Dow is up to 15,000 and stocks are hot. Sam is taking the rest of his money and investing in Dave's Dot.com and is just waiting to become a bizillionaire.
Carl's Conduit is now ready to securitize the loan. On Jan. 5, Carl's Conduit announces to Wall Street it has a pool of loans to sell. The bond market is in the tubes, and bond buyers are wanting a 9 percent return on their money--after all, they could buy U.S. Treasury bills at 8 percent, so for the extra risk of a mortgage-backed bond, they want at least 1 percent. Poor Carl! No one wants to buy the loans he made at 6 percent. In order to recoup his capital, he sells the note for $1.5 million and not only loses $500,000 of principle, but also loses all the costs of the transaction.
If ABC Mortgage had arranged for a portfolio loan instead of a conduit loan, Bob's Bank might have a similar problem. Banks operate on short-term money, such as savings deposits and borrowing from the Fed to make loans. Let's use much of the same scenario as with Carl's Conduit: When the Treasury rate increased to 8 percent, Chairman Alan Greenspan also raised the discount rate to 8 percent. Bob's Bank borrowed the $2 million it lent to Sam from the Federal Reserve at the great rate of 4 percent, and it borrowed the money for six months. When Bob's Bank had to borrow money again to "refinance" the money it lent Sam, it had to borrow it at 8 percent. Sam is only paying 6 percent, so Bob's Bank is losing 2 percent on every dollar of the loan. Sam's loan officer is now working as a relief manager at Sam's Storage.
Is It as Clear as Mud Yet?
The above examples are extreme, but they may help you understand that lenders are very careful in low-interest-rate environments to make good loans, because even if they did not lose money selling these loans, they cannot afford to have any borrowers default, which would mean they lose any interest or principle due to a foreclosure or bankruptcy. Therefore, to make "better" loans, they only advance 70 percent loan-to-value (LTV) instead of 75 percent LTV--a more conservative loan. They require the debt-service coverage (DSC) ratio to be 1.4 instead of 1.3, which simply means they make a smaller loan relative to the value. In some cases, the conservative loan underwriting does not even pay off the existing loan, such as a construction loan.
At the time of this writing (and things may have changed by press time), my company is quoting interest rates on refinance transactions at 7.5 percent to 7.75 percent for good loans (60 percent LTV, 1.6 DSC), and money is available to qualified borrowers. Borrowers can expect to pay 1 percent to 2 percent for loan-origination fees and 1 percent for loan costs (assuming the loan amount is at least $2 million). Construction loans are at prime plus 1 percent to prime plus 2 percent, and the advance rate is between 60 percent to 65 percent of cost, and 70 percent of value.
Coast-to-Coast Storage Mortgage specializes only in self-storage related loans. RK Kliebenstein, president, will be happy to explain in greater depth any of the above scenarios, and assist you in pre-qualifying for a loan. He can be reached at 561.367.9241.
Glossary of Terms
|At Loan Start||At time of adjustment|
|Index||5 percent||6 percent|
|+Margin||3 percent||3 percent|
|Note Rate||8 percent||9 percent|
Discount Rate--The interest rate the Federal Reserve System charges member banks to borrow money.
Fed--Federal Reserve Bank.
CMBS--Refers to commercial mortgage-backed securities. These securities are very similar to mortgage-backed securities in terms of structure, flexibility and variety of tranches or tiers. The key difference is that CMBS are collateralized by commercial properties and not residential mortgages.
Loans on Their Books--Loans made by an institution that have not been sold or paid off.
Sell--It is a practice for lenders to sell loans in the secondary market. If you have ever had a home mortgage, you know that to whom you send your payment or to whom you make out the check can change from time to time, meaning the bank or lender has sold your loan. In commercial mortgages, the payment is usually made to the same place (same name), but the investor or holder of the mortgage may change.
Securitization--The process of homogenizing and packaging financial instruments into a new group of loans. Acquisition, classification, collateralization, composition, pooling and distribution are functions within this process. One common advantage of securitization is the enhancement of liquidity relative to the underlying collateral or financial instrument. Another benefit is the movement toward standardization of unit specifications.
Conduits--The firms, usually investment banks, that fund the loans and put together the pools of loans to sell.
Note Rate--The rate you pay as shown on the promissory note.
Dow--The most widely used indicator of the overall condition of the stock market; a price-weighted average of 30 actively traded blue-chip stocks, primarily industrials, also called the Dow Jones Industrial Average.
Pool of Loans--See Conduit. A group of commercial loans, including all types (apartments, office buildings, self-storage, warehouse) from all over the United States, in all sizes (typically not less than $1.5 million), are all put together in a group or "pool."
The Costs of the Transaction--Appraisals, environmental reports, structural, engineering or property condition reports, lender's legal fees, surveys and inspection costs are typically paid for by the borrower when the loan is made.
Chairman Alan Greenspan--The Chairman of the Federal Reserve.
Default--Failure to make a payment.
DSC--See Debt-Service Coverage.
Underwriting--The process by which the loan request is scrutinized for the lender to make a determination if he wants to make a loan and, if so, at what rate and terms.
Qualified Borrowers--Borrowers who have good credit (scores above 700), strong net worth (at least equal to the loan amount), good income (enough left over after expenses to make 9 months worth of payments) and experience in owning, developing and managing self-storage properties.
Origination Fees--Fees charged by a lender for processing a loan application, expressed as a percentage of the mortgage amount annual percentage rate, also known as points.
Cost--The total of all costs of the project including land and soft costs. Sometimes lenders will include developer fees, interest reserves and operating deficits, while others will not.
Value--MAI appraised value.
NOI--Net operating income, including at least 5 percent management fee in addition to salaries that are well above minimum wage (and time-and-a-half for overtime, plus benefits); a replacement reserve of at least $12 per square foot and a 10 percent vacancy factor.
Mortgage-Backed Security--A broad term that encompasses generic and pool-specific securities predicated on real property. The term also refers to private-label or agency securities, pass-throughs or derivatives such as collateralized mortgage obligations. It can refer to the over-the-counter options on mortgage-backed securities as well. These mortgage-backed securities are viewed as either plain vanilla or exotic.
Tranches--The set of classes or risk maturities which comprise a multiple-class security, such as a CMO or REMIC. A tranche is the piece, portion or slice of a deal or structured financing. The so-called "A to Z" securities of a CMO offering of a partitioned MBS portfolio. It can also refer to segments that are offered domestically and internationally. Tranches have distinctive features that, for economic or legal purposes, must be financially engineered or structured in order to conform to prevailing requirements.