Capital Types and Trends

Jim Davies and Eric Snyder Comments
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What are two financing facts many storage owners are surprised to learn? One, there are more types of permanent, bridge and construction loans available today than at any time in the history of the industry; and two, lenders are more likely to add “custom” loan terms and features, even for permanent loans, if a facility has a positive track record or a new property has consistent lease-up.

Whether you are trying to fix your cost of capital for a newly or nearly stabilized property; obtain permanent financing to replace maturing, long-term debt; secure bridge financing to “take out” a construction loan or buy out an equity partner; or secure construction-loan funding for a development in a good market, it’s a great time to seek financing. However, it’s important to have an existing property with a positive history or a development site with a competitive advantage in a strong market to lock in the most competitively priced capital.

Permanent Loans

Many investors believe there is only a small price variation and minor differences in loan structure from one lender to the next for long-term, fixed-rate, permanent financing. The good news for owners is this is far from the truth in today’s aggressive lending market. One reason for the pricing differential is there are still only a handful of capital providers who fully understand storage as a property type and have a track record of trading self-storage paper in the secondary market.

As most investors know, 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 proceeds to pay off the construction loan and return most or all of the original equity capital to the developer-owner and any investor partners. With fixed interest rates at 40-year historical lows, most investors are pushing to lock in their cost of capital, whether they are taking out a loan, coming out of an existing fixed-rate loan with a yield-maintenance or defeasance prepayment penalty, or purchasing a new facility.

At the writing of this article, it is possible to obtain five-, seven- or 10-year fixed rates in the 4.75 percent to 5.75 percent range at loan amounts up to 80 percent of value. If you are looking for a loan that is 65 percent loan-to-value or less, you can obtain a 10-year fixed rate in the low 5 percent range. Most of these loans are amortized over 25 or 30 years and funded by lenders who trade them as part of a billion-dollar portfolio in the commercial mortgage backed securities (CMBS) market.

The exception would be a life-insurance company, which usually can’t match the same leverage and low cost of today’s CMBS or conduit loans. It may, however, provide a shorter-term, fixed rate-loan with a declining prepayment-penalty schedule during the last several years of the term. The other exception is a local bank that will offer a fixed rate to a preferred customer; however, it is very rare that a local bank can compete on rate or loan proceeds with a CMBS fixed-rate loan.

In the past, it was the intent of many owners who secured long-term, fixed-rate loans to hold onto their properties over the long haul. This was because they knew the loans were essentially prohibited from prepayment due to the high cost of yield maintenance or defeasance. 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 interest-rate cycle, even owners who have a short-term investment horizon are placing long-term, fixed-rate loans on their properties. They either believe the prepayment penalty will be nominal at the time of payoff, or they want to lock in these low rates to make their properties more marketable. Owners who secured fixed interest in the 8 percent or 9 percent range years ago are looking to replace it a rate below 6 percent. Consequently, the defeasance or yield-maintenance calculations add up to an onerous prepayment penalty.

Recent trends in permanent financing include the ability to lock in all or the majority of loan proceeds for a facility that is still in its final stage of lease-up by working with a lender who will offer a “customized” loan structure. One example is bridging the shortfall of net operating income needed to qualify for the desired loan amount with a letter of credit.

Another example is structuring an earn out, whereby you fix the majority of loan proceeds today and earn out the balance by increasing net operating income over a six- to 12-month period. Furthermore, lenders are willing to offer leverage exceeding the normal 75 percent loan-to-value limit and 30-year amortization on a case-by-case basis.

Finally, it is important to understand that to qualify for low, fixed-rate loans, you must be able to satisfy requirements mandated by the secondary or CMBS market. specifically, you will need to form a Single-Purpose Entity as the ownership body of the property. This means you cannot own the property as an individual, and the entity you form can’t be engaged in any other business than the operation of the facility.

Bridge Loans

The purpose of a bridge loan is to provide a relatively short term with little or no prepayment penalty, during which time an owner can maximize the income potential of a property before securing long-term, permanent financing. This may include an “added-value” purchase to increase occupancy and net operating income at a facility that has been poorly managed, or an expansion for an owner with the ability to increase revenue by adding net rentable square feet. A bridge loan may be used to provide stabilization of an asset with a maturing construction loan that has experienced a longer lease-up period. A lower-interest, nonrecourse bridge loan may also be used to replace a recourse construction loan with a higher “floor’” interest rate.

Depending on a facility’s economic occupancy and corresponding debt-service coverage ratio (DSCR), bridge loans may be non-recourse, recourse or partially recourse. Most are priced over LIBOR, though some banks still base their loans over the Prime Rate. The LIBOR-based pricing for many bridge loans is in the 4-percent to 5.5-percent range, depending on the degree of leverage, the quality of the asset and the financial strength of the borrower.

The exception would be borrowers who qualify for bridge loans offered by national “money-center” banks. These institutions may provide a partial-recourse loan that “burns off” for properties that have reached or surpassed the breakeven DSCR. These bridge-loan rates are in the 3.5 percent to 5 percent range. It’s important to note that if your bridge loan is nonrecourse, the “nonrecourse” applies to most everything except fraud, misrepresentation and environmental contamination.

Flexibility is a key aspect of a bridge loan. The borrower’s exit strategy is to move into a permanent fixed-rate mortgage or sell the facility; therefore, the financing can’t be constrained by a significant prepayment-penalty structure. Another potential feature of a bridge loan is the ability to negotiate an earn-out component to receive additional loan proceeds based on increasing the properties’ income. This may involve the expansion of anexisting facility or be as simple as increasing the occupancy and income through improved management.

Furthermore, the length and terms of bridge loans vary, and most of them have either no lock-out period or a very short one in which prepayment is restricted. If they have a prepayment penalty, it is relatively low and goes away in a short time. For example, some bridge programs are locked out to prepayment during the first year, a 1 percent penalty in the second year, and decline to no penalty in the final year.

A recent trend in self-storage bridge lending is the ability to fund loan proceeds equal to 100 percent of total project costs to facilitate the buy-out of a partner or an outright purchase from a third-party owner. One big difference between a bridge and a construction loan is if there has been enough seasoning at a property, the lender will offer significantly more loan proceeds equal to 75 percent of appraised value, as opposed to the 75 percent 80 percent of project-cost leverage restriction found in a typical construction loan.

Construction Loans

Construction loans are typically provided by money-center banks, strong regional banks or smaller local banks. This is true whether you are building a new facility from the ground up or expanding an existing one. It makes sense to call an experienced self-storage lender with whom you already have a working relationship, because it 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 it makes sense to build a new relationship, or they want to take advantage of a competitive bid process between multiple banks to ensure they secure the most aggressive loan possible.

The market is always changing. Some banks are extremely competitive during one quarter, only to exit the market the next quarter because they have reached their self-storage lending limit. This is why it makes sense to nurture multiple relationships. Once you have selected the bank that best meets your needs, it’s important to understand its underwriting criteria for the borrower and property to avoid misunderstandings during the loan process.

If you are starting a new banking relationship, understand that most banks will want to see experience successfully building and stabilizing self-storage properties. They will also want to review the results of a professional feasibility study. The most competitive construction lenders require full recourse or personal liability to the individual principals; therefore, they will scrutinize your personal financial statement to determine if you meet their net worth and liquidity requirements. The rare exception to this is when a financially strong borrower convinces a bank to accept recourse only to a specific entity, and then capitalizes the entity to a level that satisfies the bank.

Next, the bank will completely analyze your monthly construction, lease-up and operating pro forma, which will include your projections of rental income, economic occupancy, number of months to stabilization, expense ratios, etc. Your projections will be compared to the market, so you must make a strong case. Furthermore, your projected costs to build the facility will be compared to those of other facilities recently developed in the area.

Once you meet the bank’s lending criteria, you can secure a low interest rate, which can range from 3.5 percent to 5.5 percent for a loan that provides up to 75 percent or 80 percent of total project-cost financing. The range in interest rates is based on your developer’s financial statement, the type of bank interested in the project, your storage track record, the size of the loan request, the market demand for the facility, and the quality of the project’s location.

If you have a net worth of approximately two times the loan amount and at least 10 percent to 20 percent of it is liquid, you might qualify for one of the money center bank’s financing programs. These institutions generally offer LIBOR- or Prime-based rates in the 3.5 percent to 4.75 percent range. That said, they have very different qualifying criteria. For example, some will not budgeoff their 10 percent to 20 percent liquidity requirement and will ask that you maintain that 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 storage facilities and enjoy a significant annual cash flow from your portfolio.

If a money-center bank’s criteria are too stringent, one of the strong regional banks that offer the same LIBOR- and Prime-based rates but typically use floor interest rates in the 4.75 percent to 5.5 percent range can be a great source of capital. 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 similar terms and extension options.

There are some non-bank institutions that offer non-recourse or partial-recourse construction financing. These lenders are rare and are typically selective as to the types of deals they will fund. Because their only recourse is to the real estate, there must be strong market evidence to support the demand for your project. One attractive feature to this higher-cost construction financing is it may provide up to 85 percent loan-to-cost financing. Today, these lenders have floor interest rates in the 6 percent to 7.5 percent range. They may charge higher origination fees and/or exit fees and may include prepayment penalties in their loan structure.

Whether or not 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 factors in the impact a floating rate loan may have on his cash-flow projections and corresponding return on investment.

Recent construction-lending trends include the ability for money-center banks to offer an option with a significant net worth and liquidity, with the lowest LIBOR-based construction loans, to swap out their LIBOR-based, variable- rate financing for a fixed rate for 12 or 24 months. The cost to swap the rate varies, depending on what the interest-rate “futures” market believes will happen over the next couple of years. Another trend is for lenders who understand storage to offer longer construction- loan terms, like 36 months, to give facilities time to stabilize.

The good news is owners enjoy a wide variety of competitive 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 lenders add their margins or spreads to these indices, it equates to variable-rate loans from the mid-3 percent to the mid-5 percent range. The fixed-rate lending market is just as favorable. Most fixed-rate loans are priced over U.S. Treasuries, also at historical lows. Add the additional spread to today’s 10-Year Treasury, and it’s possible to obtain loans in the high 4 percent to the high 5 percent range for five, seven or 10 years.

Jim Davies and Eric Snyder are principals of Buchanan Storage Capital, which delivers debt and equity capital to the self-storage industry nationwide. For more information, call 800.675.1902; visit www.buchananstoragecapital.com.

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