Many first-time self-storage developers assume a construction loan is similar to permanent financing. But approaching financing from this perspective may create long-term negative consequences. Construction and development financing is radically different from other credit facilities. It is approached uniquely from all four of these perspectives: 1) lender, 2) borrower, 3) risk analysis and 4) underwriting. If the lender is inexperienced in self-storage lending, he may not fully understand the idiosyncrasies of the product type and make mistakes based on unfamiliarity.
The Greatest Mistake
Many a borrower and lender have made the mistake of structuring their construction loan in a way that would be acceptable for other real estate types, meaning as a typical two-year, interest-only loan. On the surface, this works great. It only takes six to eight months to build a project, so it would seem two years should be ample time. But consider the following timeline:
1. If all goes well and construction starts near to the close of the loan, this assumes permits are in hand.
2. In a typical project of 50,000 square feet, this assumes a gain of 1,875 to 2,500 square feet per month, which likely means renting 2,000 to 2,750 feet per month (pessimistic and optimistic, respectively).
3. Most permanent-loan lenders want to see six months to a year of seasoned cash flows to feel comfortable with the debt-service coverage. Keep in mind the higher the DSC, the greater the opportunity for the borrower to negotiate a better rate.
Most banks do not make construction loans for longer than a year, and only a few go to two years. What do you do? Look for a construction lender that will grant a hybrid of the construction and short-term permanent loans. The “mini-perm” is becoming more popular with banks and construction leaders. It is typically 12 to 18 months of interest- only, pure construction loan. After the interest-only portion, the loan adjusts every six months, increasing in amortization as the cash flows support higher debt-service coverage (DSC). Here is an example of a well-negotiated, win-win mini-perm loan:
This will provide the borrower proven cash flows with at least 1.40 DSC (target) and that are seasoned for at least one year above 1.25 DSC (minimum). If necessary, a six-month extension (or two) should be negotiated. Expect to pay two points on the front end for this loan, and a point for each six-month extension.
Some banks will require full personal guarantees for the entire mini-perm loan term. Strong borrowers may be able to negotiate a “burn-off” of recourse as the cash flows mature. This loan provides the lender (bank) with an assurance the project is able to sustain itself and the borrower could refinance at 1.25 DSC.
Negotiating the Best Loan
Your feasibility-study consultant should be able to assist you in the loan-negotiation process. Assuming he determines the project is strong and the cash-flow pro formas and budgets support the DSC, he can provide the bank with breakeven-analysis and sensitivity reports that will help it feel comfortable with loan terms most favorable to the borrower.
Your feasibility study should include a loan request with all the salient loan data the bank will be looking for, including important ratios and even your tax returns and financial statements. A good consultant will have referrals to lenders who are accustomed to underwriting permanent loans for self-storage. He may or may not have suggestions for construction lenders, as the construction loan is typically a “relationship” loan, which means the borrower is likely to already have some credit facility with the lender.
Since a construction loan does not have the strength of the collateral (a project that fails to complete construction is worth significantly less that a finished product), the lender must rely more heavily on the strength of the borrower. The borrower should have development expertise and experience, or the lender will substitute borrowing experience or equity. He should also be able to demonstrate self-storage experience, especially if the lender is sophisticated. A novice self-storage lender may not understand how critical strong management skills are during lease-up. Many banks incorrectly assume a proven track record in real estate means the borrower will be successful in the selfstorage endeavor.
The three Es—experience, expertise and education—can almost always be substituted with financial strength. The lender will often look to the three Cs—credit history, character and cash—to supplement a weak experience factor.
Self-storage construction loans are a unique product for many lenders. You should prepare for you initial meeting. Prior to face time with the bank or construction lender, ask the following questions:
1. Do you make self-storage mini-perm loans?
2. Is the project’s location within the lending footprint of the bank?
3. Is the loan size within the limitations of the bank or will it require a participant?
4. If the bank requires a participant, does it have one for a selfstorage loan?
5. Have you ever made a self-storage loan?
If the answer to these questions is “yes,” set up an appointment to meet. If the answer to No. 5 is “no,” you will want to know more about how the approval process is going to work. A negative response in this case can actually work in your favor if you have a weak or marginal project.
RK Kliebenstein, president of Coast-to-Coast Storage, is a former commercial lender and provides feasibility studies and financial consulting to self-storage developers. He can be reached at 877.622.5508, ext. 81.