This was the most difficult article to write. I was presented with the task of writing it just before one of our country's most trying times: the terrorist attacks on the World Trade Center and the Pentagon. Like many other people, I now have a new understanding of how trivial many of our daily activities and priorities are.
I have decided to write a lighthearted article about financing, which is my livelihood and something I regard with extreme seriousness and diligence. I say lighthearted because in the last few days, I realized these issues are minor in comparison to the profound devastation that has been brought upon our country. My thoughts and prayers continue to be with the victims of this tragedy and their friends and families.
The television show Who Wants to Be a Millionaire? was a hit when it made its debut two years ago, and it's still going strong. Let's play the self-storage financing version of this popular game. (But please understand: The dollar amount specified for each question is for illustrative purposes only!) Let's play!
Fastest Finger question: Please put in order (from lowest to highest), the monthly payments on the following loans, given the same loan amount and interest rate:
a) A loan with a 25-year amortization
b) A loan with interest only
c) A loan with a 15-year amortization
d) A loan with 20-year amortization
Answer: b, a, d, c. The longer the amortization period (or the period of time in which principal is paid down), the lower the monthly payment. In the case of an interest-only loan, no principal is paid down on a monthly basis.
$100 question: What is the color of money?
Answer: b) Green. From a financing perspective, the real questions are 1) how to optimize your access to money and 2) the terms in which it is available.
$200 question: Loans made for developing a self-storage property are called:
a) Construction loans
b) Permanent loans
c) Mezzanine loans
Answer: a) Construction loans. A construction loan is made based on the project's estimated cost. Typically, it is provided in draws based on the project's completion and its payments are interest- only for a two- to three-year period. Many construction loans then have the option to convert to an amortizing loan for a specific time period. All construction loans are recourse, which means you personally guarantee the loan payment.
Permanent loans are generally based on the property's operating income and are made after you have stabilized operations. They come in all forms, and you should seek a loan with terms that most closely suit your investment strategy. Mezzanine loans are sometimes available as a second tier of financing for a loan that exceeds 75 percent of value. Mezzanine loans are usually only available for larger projects or portfolios.
$300 question: LTV refers to:
a) Local tax voucher
d) Load the vault
Answer: b) Loan-to-value. This refers to the loan amount as a percentage of the appraised value. This is the lender's most important criteria in determining how much money to lend you. Most lenders base loans on a maximum of 65 percent to 75 percent of appraised value.
$500 question: DSC refers to:
a) Debt-service coverage
b) Default-standard covenant
c) Debt-servicing contract
d) Debtor's second chance
Answer: a) Debt-service coverage. Along with LTV, the second most important criteria for lenders is the DSC. For self-storage properties, lenders are currently quoting between a 1.25 and 1.40 DSC. The DSC is based on an "underwritten operating income" determined by the lender. Typically, this underwritten net-operating income is based on the trailing 12 months. Lenders will also adjust the net-operating income to account for nonrecurring income and expenses, management fees and replacement reserves. Except for instances when a property is in lease-up, the maximum LTV will be the criteria that will establish your loan amount.
For example, a stabilized property appraised at a 10 percent cap rate may obtain a loan for 75 percent of value, which may equate to a DSC of 1.40. Please also read and understand your loan application because your DSC may be based on a minimum (floor) interest rate or constant (the annual debt payment in comparison to the beginning loan amount).
$1,000 question: A recourse loan requires the loan be secured by:
a) The property only
b) Other assets
c) The facility and other assets
d) Your word
Answer: b) The facility and other assets. A recourse loan is made based on the borrower's financial wherewithal and credit strength, in addition to the underlying asset's strength. There are also nonrecourse loans and partial-recourse loans. Partial-recourse loans limit the amount of the loan guaranteed by the borrower. Most nonrecourse loans are associated with loans that are securitized (conduit loans). These loans are made based on the continued operating viability of the underlying self-storage property. Nonrecourse loans have "carve-outs" that exclude such acts as fraud, misapplication of funds and all environmental risks.
$2,000 question: Which of the following is not an index used in determining mortgage interest rates?
c) 10-year Treasury Yield
Answer: d) NASDAQ. Certainly the stock market has a profound effect on the financial marketplace and has direct correlation to the indices mortgages are based on. LIBOR (London Interbank Offered Rate) and prime are generally associated with construction loans and variable-rate loans. LIBOR is quoted daily in business newspapers and compares most closely to the one-year Treasury Security Index. The 10-year Treasury Yield is generally used as an index for 10-year fixed-rate money. During the current uncertain business climate, these indices may show signs of extreme volatility, thus forcing lenders to apply overriding floors and ceilings in their interest rate provisions.
$4,000 question: Which of the following is not a form of a prepayment provision (penalty)?
a) Treasury defeasance
b) Sliding scale
c) Yield maintenance
Answer: d) First-born. Treasury defeasance refers to replacing the cash flow that would have been generated by your monthly mortgage payments with Treasury securities that would yield equivalent payments. Sliding scale refers to a prepayment penalty as a percentage of the outstanding balance. Yield maintenance is similar to Treasury defeasance except you pay a lump-sum penalty at the time of loan payoff based on your note rate in comparison to current indices. These formulas are explained in greater detail in various loan documents.
$8,000 question: To obtain permanent financing, occupancy generally needs to be higher than:
a) 50 percent
b) 70 percent
c) 75 percent
d) 100 percent
Answer: c) 75 percent. Most lenders expect a facility to be at least 75 percent occupied, physically (as a percentage of square feet) and economically (as a percentage of potential rental income). Please keep this in mind when developing your sites. Larger facilities take longer to lease up. In many cases, developing a facility in phases could very well be the best business plan.
$16,000 question: Conduit loans are:
a) Kept on the bank's balance sheet
b) Securitized on Wall Street
c) Fully recourse
d) Good for expansions
Answer: b) Securitized on Wall Street. Lenders typically do not keep these types of loans as an asset on their books for a long time period. Conduit loans are pooled with other commercial loans and used as collateral by investors who buy securities, which then serve as their security investments. Their investment returns are funded by the cash flow generated by the underlying mortgages. These loans are made to the facility owner on a nonrecourse basis (with standard carve-out exceptions) and are long term in nature. However, you will be unable to secure additional funding or secondary funding for these loans. Accordingly, facilities still in expansion would generally not be good candidates for a conduit loan.
$32,000 question: Which of the following items are generally discounted or not allowed as income by a lender?
a) Late fees
b) Administrative fees
c) Truck-rental fees
d) Lock and box sales
Answer: c) Truck-rental fees. All of the other income items listed are typically considered part of continued self-storage income. Most lenders limit the amount of "other income" ("other" meaning excluding rental income from self-storage units and parking) to not more than 6 percent. In circumstances where historical income supports a higher percentage, lenders may make exceptions. Truck-rental income can be discontinued at any point and is, therefore, either discounted or not taken into consideration by most lenders.
$64,000 question: B-piece buyers buy:
a) First-generation self-storage properties
b) Auctioned units
Answer: c) Securities. Conduit loans are sold as CMBS (commercial-mortgage backed securities). B-piece buyers invest in the riskier portions of the securities offered in the CMBS marketplace. These investors are at higher risk when borrowers default or if other unforeseen events occur. There are fewer than 10 active B-piece buyers, and the CMBS marketplace is very much at the mercy of these investors. Prior to securitizing a pool, B-piece buyers can discard any loan from a mortgage pool they deem is unfit for their investment criteria. Therefore, securitized or conduit lenders have become increasingly more diligent in underwriting loan requests. Self-storage properties with superior historical results, management, location and physical attributes will continue to have better access to capital and more beneficial deal terms.
$125,000 question: What is the approximate value of securitized self- storage loans?
a) $1 billion
b) $2 billion
c) $3 billion
d) $10 billion
Answer: c) $3 billion. There have been nearly $3 billion of self-storage loans securitized representing slightly more than 1,100 properties. In comparison, approximately 18,000 retail and 18,000 multifamily properties have been securitized. Self-storage properties have performed very well in comparison to other property types. In fact, self-storage enjoys the lowest default rate. This information is provided by Trepp LLC, a leading provider of CMBS data.
$250,000 question: In efforts to support our economy, the Federal Reserve Bank (Fed) has decreased the discount rate several times this year. What always happens when the Fed lowers the discount rate?
a) Rates on variable-rate loans decrease
b) Rates on fixed-rate mortgages decrease
c) Rates on variable- and fixed-rate loans decrease
d) You are able to obtain a larger loan
Answer: a) Rates on variable-rate loans decrease. When the Fed lowers the discount rate, it in effect lowers "short-term" interest rates. Variable-rate loans may not be short term, but they are generally linked to "short-term" indices, such as the prime rate, LIBOR or one-year Treasury. In taking this step, the Fed's intent is to enable property and business owners to borrow at a lower rate for development and infrastructure. However, even with lowered interest rates, lenders are being more conservative with loans they provide their customers.
Many fixed-rate mortgages are based on "long-term" indices, such as the 10-year Treasury Yield, which increases or decreases based on two main factors: 1) supply and demand and 2) inflation risk. Even when the Fed has lowered the discount rate, it isn't uncommon for the 10-year Treasury Yield to increase because of the market's concern over higher inflation.
$500,000 question: In the future, mortgage interest rates are more likely to:
a) Be below 7 percent
b) Be between 7 percent and 8 percent
c) Be above 10 percent
d) Be between 8 percent and 10 percent
Answer: Poll the audience! Throughout the year, my clients have taken advantage of some of the lowest rates ever offered by capital sources. It is extremely difficult--even impossible--to predict future rates. The only thing we do know for certain is interest rates will continue to increase or decrease. With the financial market's current unique circumstances, many lenders have actually put floors or minimums on the interest rate at which they will loan money. I would say your risk of interest rates rising greatly outweighs the possibility of interest rates falling further.
$1,000,000 question: Capital is going to:
a) Be abundant in the future
b) Be available for only "A" properties
c) Be non-existent in the future
d) Be as available as it is today
Answer: Call a lifeline. As its familiarity with the industry grows, the lending community's appetite for providing self-storage loans has been increasingly stronger during the past several years. Each lender has unique objectives and subjective criteria that dictate its desire to lend you money. There is certainly a trend in which higher-quality self-storage operators enjoy better loan opportunities as lenders become more cautious.
Who is your best deal advocate? That depends. Consider short- and long-term investment objectives in determining your financing request. Most of the lenders are no longer actively promoting their programs to our industry directly at tradeshows or through industry publications. It may be wise to seek the services of a mortgage banker/broker whose full-time job is to work with capital sources to obtain the best overall deal.
Thanks for playing, and may all of you become winners when financing your self-storage properties.
Neal Gussis is a senior vice president at Beacon Realty Capital Inc., a financial-services firm that arranges debt for self-storage and other commercial real estate owners. Mr. Gussis has arranged financing in excess of $500 million for his self-storage clients. He can be reached at 312.207.8240 or email@example.com.