Recent stock market meltdowns have caused investors many sleepless nights. Overnight, they find an earthquake in their IRA account. Years of saving for retirement are wiped out without warning. Yet the self-storage investment remains virtually undisturbed by perturbations in the market. Little known to stock investors is the veracity and stability of the self-storage industry.
For example, there are fewer foreclosures on self-storage loans than other types of commercial loans. Also, selfstorage is countercyclical. In bad economic times, people downsize (in business and residential capacities) and use self-storage to store their inventories, furniture, personal goods, etc. In good times, they increase inventories, move or build larger homes/offices, using storage while in transit.
To fully appreciate a self-storage joint venture, a comparison of return rates on alternative investments is necessary. A most common and valuable gauge used to measure profit is internal rate of return (IRR), which measures return on cash flow and sales proceeds. IRR is a compounding rate of return over the life of an investment. For example, the income stream from already existing and rented income properties often (not always) looks like these examples:
One of the values of IRR is its ability to compare apples to oranges. To lend further perspective to the profitability of self-storage, the income stream for an existing apartment complex is shown:
Obviously, cap rates will vary in different parts of the country; but, generally, they fall between 9 percent and 11 percent. Financing will also vary on specific properties.
Developers can make substantial profits, but the financial clockwork for this is sometimes obscure. The key profit factor stems from how the project is financed. To illustrate, let’s look at the following example of a typical 60,550-square-foot facility:
It becomes immediately evident development profits are substantial. Generally, developers see their first major profit when permanent financing is brought online because the permanent loan is larger than the construction loan. In the above example, the additional $69,732 in year two comes from the permanent loan displacing the construction loan. This overage can often be considerably larger than in the example, i.e., with a mini-perm loan (to be explained a little later).
How do stock investors participate? Outside investors are generally not positioned with know-how, experience and credentials to develop self-storage independently. Hence, there is a mutual advantage to combine resources with an experienced developer. The investor brings money, and the developer brings grunt work and expertise. The profits from such a venture can be split in several ways. Basically, the investor puts up the funds and is given a percentage of the project. There is often a preferred return to the investor. In the examples that follow, the investor puts up the initial investment (to purchase land and provide startup costs) and secures the construction loan until the project secures permanent financing.
Several Joint-Venture Scenarios
To illustrate the financial structure of common joint-venture configurations, we’ll look at six scenarios using the income stream from the previous self-storage development example. Each scenario is reduced to an overall IRR for convenient comparison. Refer to the charts for all calculations.
No Preferred Return (50/50 Split). The investor puts in $504,380. There is no preferred return. The initial investment of $504,380 is returned at sale before other sales proceeds are split. The cash flow and the remaining sales proceeds are split 50 percent to the investor and 50 percent to the developer. The IRR is 22.80 percent.
With Preferred Return (50/50 Split). The investor puts in $504,380. There is preferred return of 3 percent in the first year of operation and 7 percent thereafter. The initial investment of $504,380 is returned at sale before other sales proceeds are split. Cash flow and the remaining sales proceeds are split 50 percent to the investor and 50 percent to the developer. The IRR is 25.12 percent.
Preferred Return and Loan Proceeds (50/50 Split). The investor puts in $504,380. When the permanent loan comes on line, the $69,732 is paid to the investor from loan proceeds as part of the preferred return, thus reducing the exposed investment. There is preferred return of 3 percent in the first year of operation and 7 percent thereafter. The remaining initial investment of $434,648 is returned at sale before other sales proceeds are split. Cash flow and the remaining sales proceeds are split 50 percent to the investor and 50 percent to the developer. The IRR is 25.59 percent.
60/40 Split With Preferred Return. The investor puts in $504,380. There is preferred return of 3 percent in the first year of operation and 7 percent thereafter. The initial investment of $504,380 is returned at sale before other sales proceeds are split. Cash flow and the remaining sales proceeds are split 60 percent to the investor and 40 percent to the developer. The IRR is 28.09 percent.
Developer Equity Participation (67/33 Split). The developer essentially builds the project for cost plus 10 percent. He then buys into the project with $165,067, which is the 10 percent profit from construction. He thus acquires a 33 percent position in all cash flow and sales proceeds. The investor secures the construction loan and owns 67 percent of cash flow and sales proceeds. The IRR is 38.35 percent.
Developer Equity With Preferred (67/33 Split). Again, the developer builds the project for cost plus 10 percent. He buys into the project with $165,067, which is the 10 percent profit from construction. The investor secures the construction loan, and owns 67 percent of cash flow and sales proceeds. The investor also receives a preferred return of 3 percent in the first year of operation and 7 percent thereafter on the exposed investment. The developer acquires a 33 percent position in all cash flow and sales proceeds. The IRR is 39.69 percent.
‘He Who Has the Gold Rules’
Very often, investors focus on getting control and insisting on a bigger percentage of ownership in a project rather than looking at their bottom line. In fact, an investor is really better off having the developer be profitable rather than squeezed. Suppose the investor returns were 35 percent IRR in the first example of a 50/50 split with no preferred return? If an investor gets an acceptable return, does it really matter what percentage of the project he owns?
Instead of making profit by taking more from the developer, investors are further ahead by creating win-win situations. The last thing investors and developers need is to be sitting around the conference table with expensive attorneys wrangling about who gets what. The better idea is to create a profit by financial structuring and let the project work for you instead of you working for it.
Also, the better investors understand the financial clockwork, the less motivation it takes to protect the investment. A comprehensive pro forma over the entire life of the investment will take the stress out of this decision-making. The key for investors is to find the right broker and developer who are skilled and surgical at financial structuring.
Does this translate into risking all? Absolutely not, because the contractor is generally bonded, meaning completed construction is insured. Second, the lender has recourse to the bonded project including the land. Generally, the loan amount is 75 percent to 80 percent of the project cost including the land. Therefore, any additional recourse provided by an investor would cover only the difference between the foreclosed value and the loan amount.
A more likely “worst case” scenario is the project does not rent-up as anticipated. At this point, the investor has to reach into his own pocket to make payments, or rather, the difference between available funds and the amount of the loan payment. This scenario points to the importance of implementing interest reserve correctly, which will ensure positive cash flow in early months.
What Is Interest Reserve?
Interest reserve has the effect of a loan making its own payments for a limited time. The principal balance of the loan is increased for each payment made. It is important that financial structuring and packaging include exact, monthly interest-reserve calculations, because if the property does not meet rent-up expectations, there will have to be a “cash call” to investors to make up the difference.
In the example, the project is in a negative cash flow position of -$24,704 during construction and -$127,694 in the first years without the use of interest reserve. Then, by using interest reserve, the project can be put in a positive cash-flow position of $19,079 at the end of the first year of operation— a total positive effect of $171,477. (The details of this calculation and exhibits are available upon request.) Almost certainly, a need for additional cash contingency beyond interest reserve should be provided for and resolved in the joint-venture agreement. Thus, the perception that the investor is “risking all” is more often an untrue knee-jerk reaction, especially if the developer has hard equity invested as in the last scenario and is sharing 33 percent of the risk in the land.
Two developers can structure financing for the same development and arrive at opposite ends of profitability. This underscores the need for investors to focus more on competent financial structuring instead of arm wrestling for a larger slice of pie. For example, the careful use of a mini-perm loan can have an enormous effect upon profitability.
The concept of the mini-perm loan is to provide a transition from the construction loan to a permanent loan. In the same example, let’s say a construction loan remains in place for two years and a mini-perm loan is available, using the last six months of NOI to establish a value based upon the income approach.
Use of a mini-perm loan can add a whopping $336,023 to cash flow in year two. Adding this to the $171,477 saved as a result of using interest reserve has a total impact of $507,500. Developers should consider adding these aspects to their analysis and financial packaging, while investors should make sure these two factors have been considered. Revising spreadsheets to accommodate these factors monthly and testing several “What if?” scenarios will create win-win situations for developers and investors.
Jim Oakley is a pioneer and national authority in computer modeling of financial feasibility. His methodology was taught at Arizona State University and its Center for Executive Development. He has addressed major national conventions including the ISS expo, National Association of Corporate Estate Executives and the National Association of Real Estate Educators. His articles have appeared in Inside Self-Storage, Professional Builder and Lodging magazines. Mr. Oakley consults from Prescott, Ariz. For more information, call 928.778.3654; visit www.mrfeasibility.com