Loan Types And Lending Options

Eric Snyder and Jim Davies Comments
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Just as there are many types of self-storage facilities, there is a diversity of financing options available in the capital markets. Some self-storage owners seek floating rate financing, while others prefer fixed-rate loans. Some ownerdevelopers want construction financing to build a new facility, some require bridge financing to “take out” a construction loan, and others need permanent financing to replace existing long-term debt that is maturing.

Selecting the right loan for your particular situation becomes even more complicated as you sift through the different loan variables, such as recourse provisions, prepayment penalties, amortization, loanto- value, debt-service coverage ratios, etc. The good news is there are enough financing options available in the capital markets to satisfy virtually any financing request. The variety of options can be categorized into three main loan types: construction, bridge and permanent. However, different types of capital sources offer many different financing structures and programs within each of these three categories.

Construction Loans

Construction loans are typically provided by regional or local banks to build a new facility or expand an existing one. Obviously, your first call should be to an experienced self-storage lender with whom you already have a working relationship, because he will likely offer the most aggressive loan terms, rate and structure.

However, some borrowers will benefit from the services of an experienced mortgage banker or broker when: 1) they do not have a strong existing banking relationship; 2) it makes sense to build a new banking relationship; or 3) they want to take advantage of a competitive bid process between multiple banks to ensure they secure the most aggressive loan possible. The banking market is so fluid— with some banks being extremely competitive at one point in time only to exit the market at another—it makes sense to nurture multiple relationships.

Once you have zeroed in on the bank you believe will best meet your needs, it’s important to understand its underwriting criteria for the borrower and property so there are no major surprises during the loan process. Even when you enjoy an existing relationship with a bank, its criteria can change from time to time.

If you are beginning a new banking relationship, it’s important to understand most banks will place enormous weight on your self-storage experience, self-storage track record and the results of a feasibility analysis. This is especially critical in today’s market in which many facilities are taking much longer to lease up.

Construction lenders that offer the most competitive interest rates will require full recourse to the individual principals; therefore, they will scrutinize your personal financial statement to determine if you meet their net worth and liquidity requirements. The only rare exception to this is when a financially strong borrower convinces a bank to accept recourse only to a specific entity and then capitalizes this entity to a level that satisfies the bank.

Next, the bank will completely analyze your pro forma lease-up and operating statements that take your facility through stabilization, including your projections of rental income, vacancy, number of months to stabilization, expense ratios, etc. All of your projections will be compared to the market, so you must be able to make a strong case for a lender to use projections that are more aggressive than the actual performance of the market. Additionally, your costs to build the facility will be compared to those of other facilities recently developed in the market.

If you can get comfortable with a full recourse construction loan, you can expect to receive some very competitive interest rates. At the time of this writing, your overall interest rate can range from 3.5 percent to 6 percent for a loan that typically provides up to 75 percent or 80 percent of cost financing. The wide range in interest rates has to do with the type of bank you are soliciting, your financial strength, your track record, the size of your loan request, the market demand for your facility and the quality of your project’s location.

If you have a net worth that is typically two times the loan amount and at least 10 percent to 20 percent of it is liquid, you may qualify for one of the national “money center” bank’s financing programs. These financial institutions generally offer LIBOR- (London Inter Bank Offered Rate) or Prime-based rates in the 3.5 percent to 5 percent range. That said, these banks have very different criteria among themselves.

For example, some of these banks will not budge off their 20 percent liquidity requirement and will require you maintain that 20 percent liquidity through the entire construction-loan period. Others will allow minimal liquidity as long as you have a strong track record of developing and stabilizing quality storage facilities and receive significant annual cash flow from your portfolio.

If you do not meet the requirements of a “money center” bank, you will want to work with one of the excellent regional banks that offer the same LIBOR- and Prime-based rates but typically use “floor” interest rates in the 5 percent to 6 percent range. These loans usually provide for a three-year term with a one-year extension option, a two-year term with two six-month extension options, or slight variations of the same terms and extension options.

There are also several non-bank financial institutions that offer nonrecourse or partial-recourse construction financing. These lenders are few and far between and typically very selective as to the types of deals they will fund and the track record of the developer. Since they are non-recourse lenders and their only recourse is to the real estate, there must be strong market evidence that your project will ultimately be successful. The benefit is if they like you and your project, they may provide up to 85 percent loanto- cost financing. However, the non-recourse and higher loan-to-cost features do come with higher pricing. These lenders have “floor” interest rates in the 7 percent to 8.5 percent range, may charge higher origination fees and/or exit fees, and may include prepayment penalties in their loan structure.

Whether construction lenders require personal guarantees/recourse, their pricing is based over LIBOR and Prime, so your rate will most likely adjust during your loan term. It is important a developer assesses the impact a floating-rate loan may have on cash flow as we enter what looks like an environment of gradually increasing short-term interest rates.

Bridge Loans

A bridge loan is a very useful loan type for self-storage owners purchasing a property that has the opportunity to increase occupancy and net-operating income, such as one that has been poorly managed, or for an owner who has the ability to increase revenue through expanding the net rentable square feet of a facility. The goal of a bridge loan is to provide a relatively short term with little or no prepayment penalty, during which time the owner can maximize the income potential of the property before placing long-term, permanent financing on it.

A bridge loan may also be used to provide a “safety gap” to an owner who has a construction loan maturing on a property that has not yet stabilized to a level sufficient enough to qualify for a long-term, permanent takeout loan. In some cases, a lower interest nonrecourse bridge loan may be used to replace a recourse construction loan that included a significantly higher “floor” interest rate than what is currently achievable in the market. Some of these loans may be nonrecourse depending on the facilities’ degree of stabilization and corresponding debt-service coverage ratio and whether they are priced over LIBOR.

The LIBOR-based pricing for many of these bridge loans is in the 5.5 percent to 6.5 percent range. The exception would be for borrowers who qualify for bridge loans offered by the national “money center” banks, which may offer a partial recourse bridge loan that burns off for properties that have reached or surpassed the “breakeven” debt-service coverage ratio. These money center bridge-loan rates would be in the same range as their 3.5 percent to 5 percent construction-loan rates. Also, it’s important to note that if your bridge loan is nonrecourse, the “nonrecourse” applies to most everything except for fraud, misrepresentation and environmental contamination.

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 the form of an “earn out” as you improve the property’s income. There may also be a construction component in the loan if you are expanding the property. Furthermore, the length and terms of bridge loans vary, and most of them have favorable prepayment penalties or none at all. For example, some bridge programs are “locked out” to prepayment during the first year. They then have a 1 percent penalty in the second year, eventually declining to no prepayment penalty in the final year.

Another big potential difference between a bridge and construction loan is that if there has been enough seasoning at a facility, the lender will offer significantly more loan proceeds equal to 75 percent loan-to-value as opposed to the 75 percent to 80 percent loan-to-cost restrictions of the original construction loan.

Permanent Loans

Permanent loans are the last but, hopefully, most economically beneficial of the common loan types. Long-term permanent loans are used to take out floating-rate construction or bridge loans, typically with long-term fixed rates. The goal of the permanent loan is to secure sufficient loan proceeds to pay off the construction loan and return most of the invested equity capital to your investors and yourself.

These loans have been very popular over the past 24 months, since fixed interest rates have been at all-time historic lows. At the writing of this article, it was possible to obtain fixed rates at just under 6 percent for 10 years at loan amounts up to 75 percent of value. If you were looking for a loan amount that was just 60 percent loan-to-value, you could obtain a 10-year fixed rate in the mid- 5 percent range. Most of these loans are amortized over 25 or 30 years and are funded by lenders who trade these loans as part of a billion-dollar portfolio in the commercial mortgage-backed securities market.

In the past, it was the intent of many owners who secured long-term fixed-rate loans for their properties to hold these assets long-term. This was because the owners knew these loans were virtually prohibited from prepayment due to the high cost of yield maintenance or defeasance prepayment penalties. Also, at the time, rates in the 8 percent to 9 percent range were attractive compared to the double-digit rates previously available.

However, since we are most likely at the bottom of the cycle in this historically low interest-rate environment, many storage owners who have a shorter-term investment horizon are placing long-term fixed-rate loans on their properties. They are making this choice either because they believe the prepayment penalties will be nominal in the future—when rates are higher at the time of loan payoff due to the way prepayment penalties are calculated—or they want to lock in these extremely low rates to make their property more marketable during the next several years.

Owners who tied up fixed interest rates many years ago and are trying to pay them off often are looking at replacing an interest rate of 8 percent or 9 percent with an interest rate that is below 6 percent. Consequently, the defeasance or yield maintenance calculations are generating exorbitant prepayment penalties.

However, many owners who are placing fixed rates on their properties at all-time historic lows below 6 percent believe that at the time they consider prepayment, if ever, the rates will likely be a couple of percentage points higher. As a result, their prepayment penalty may be relatively low or nonexistent if interest rates at the time of prepayment have increased enough. Also, they believe they will command a higher price for their facility if they decide to sell in a couple of years when fixed rates are in the 8 percent range and they have an assumable 6 percent fixed-rate mortgage on their property.

In addition, to qualify for these low fixed-rate loans, you must be able to satisfy requirements mandated by the secondary market. Specifically, you will most likely need to form a single-purpose entity as the ownership entity of the property. This means you cannot own the property as an individual, and the entity you form cannot be engaged in any other business than the operation of your facility.

The good news is owners enjoy a multitude of financing options and are benefiting from some of the lowest interest rates in history. Today’s variable-rate loans are priced over LIBOR or Prime, both of which are at historical lows. When the lenders add their margins to these indices, it equates to variable-rate loans from the mid-3 percent to the mid-5 percent range. And the fixed-rate lending market is just as favorable as the variable-rate market. Most fixed-rate loans are priced over U.S. Treasuries, which are also at historic lows. Add the additional margin or spread to today’s 10-year Treasury, and it’s possible to obtain fixed-rate loans in the low 6 percent range.

Eric Snyder and Jim Davies are principals of Buchanan Storage Capital, which provides capital to self-storage owners nationwide, including permanent loans, bridge loans, construction loans, mezzanine debt and equity.

For more information, call 949.721.1414 or visit www.buchananstoragecapital.com.

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