The Rundown on Refinancing

Bill Walton Comments
Posted in Articles, Finance
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If you’re thinking about refinancing your existing self-storage loan, you should be asking these questions:

  • When is the right time to refinance?
  • I have a floating-rate loan. Should I switch to a fixed rate?
  • Are there new loan products to consider?
  • I have a prepayment penalty. Should I wait until the end of my current term to refinance?
  • What will it cost to refinance?
  • How can I optimize the process of refinancing by learning from other’s mistakes?

Knowing what to look for and what to expect will help you to manage the expense category that is generally the largest monthly cash outflow a self-storage owner has: debt service (interest and principle payments). As you think about the refinancing process, some of the key elements to consider are timing, product variety, prepayment penalties, and rates, terms and costs.

Timing

Making the decision to refinance is not always easy. A due construction or permanent loan will definitely set off this event. However, when reviewing some of the other triggers, you will find more than a few require considerable thought:

  • Construction loan due
  • Permanent loan due
  • Need expansion funds
  • Remove recourse
  • Desire to pull out “trapped equity”
  • Improve cash-on-cash return
  • Interest rates low or expected to increase

Many self-storage owners do not realize they may have a considerable amount of “trapped equity” tied up in their business. Values for self-storage have increased significantly over the past few years, providing owners the opportunity to pull hundreds of thousands of dollars out of their operations. Selling your facility will free this trapped equity, but refinancing to the maximum loan-to-value will have a similar effect. Pulling this equity out through refinancing may also have some significant tax advantages.

Another reason some owners refinance their business is to increase their cash-on-cash return. Also called “return on invested capital” or “the equity dividend rate,” it measures the annual return you make (cash flow) in relation to the cash invested (or current equity). One way to increase this figure is through refinancing. The higher the cash flow and the lower the cash invested, the higher your return will be. In other words, the more of a lender’s money you can use to finance your facility, the higher your cash-on-cash return.

Another trigger that may come into play is the opportunity to lock in a low interest rate. This has been particularly relevant over the last few months, as rates have started to move up from historical lows. Borrowers with floating-rate loans, such as those tied to the Prime Rate, are especially vulnerable to higher interest expense. A variable-rate loan may be right for you if you plan on paying it off in the next few years. But as the general consensus is short-and long-term rates are headed up, the timing may be right to refinance with a fixed-rate loan.

Loan-Product Variety

What used to be a relatively small list of loan products from which a self-storage owner could choose has branched into many alternatives. This is good from a borrower’s perspective, but finding and selecting the right product to fi ts your needs can be difficult. To give you an idea of the many loan features available, here is a partial list:

  • Fixed and floating interest rates, with loan terms of three, five, seven, 10, 15 and 20 years
  • Amortization periods up to 30 years
  • Interest-only for “x” number of months
  • Multiple prepayment-penalty options
  • Fixed fees and closing costs
  • Early rate-lock options
  • Recourse and nonrecourse
  • Low-cost, variable-rate bonds Many of these features can be combined.

For example, a borrower could select a fixed-rate, 15-year loan with a 25-year amortization period and interest-only for the first 24 months. There are many other options.

Prepayment Penalties

Most long-term loans (longer than five years) taken out over the past seven to 10 years have some form of prepayment penalty. Just because there is a penalty, however, does not mean you can’t refinance. It does mean you should perform a cost vs. benefit analysis before proceeding. It is always worthwhile to do a cost vs. benefit analysis when interest rates are low and values are high; interest rates are high and values are high; or there are other cash needs. It is generally not worth doing an analysis when interest rates are low and values are low; or interest rates are high and values are low.

When preparing for a refinance, become familiar with the following types of penalties. While there is probably some debate over which is the “worst” (pick your poison), this list presents them in sequence of what is considered to be most favorable to least favorable:

  • Step-down
  • Flat-fee
  • Yield-maintenance
  • Defeasance
  • Lock-out

While there isn’t space in this article to adequately cover each of the penalty types, it is important to match your needs to the alternatives. You should also be aware there is generally a cost, in terms of higher interest rates, associated with the most favorable prepayment clauses. Don’t let a prepayment penalty prevent you from taking advantage of the benefits of a new loan or from pulling out needed trapped equity. Do the analysis or get someone to assist you.

Interest Rates, Terms and Cost

There are a lot of variables to weigh in a refinancing transaction. Many affect the interest rates, terms and cost of a loan. The following will give you an idea of these variables for a long-term, nonrecourse loan:

  • Net operating income (NOI)
  • Ability to cover debt service
  • Requested loan-to-value (LTV)
  • Percent occupancy (physical and economic)
  • Loan amount
  • Roof tops/population (in a 15-mile radius)
  • Size (rentable square feet)
  • Competition (in 5-mile radius)
  • Quality of construction/age of facility
  • Ratio of climate-control units
  • Market occupancy
  • Visibility/drive-by traffic
  • Credit worthiness of borrowers
  • Rental rates and rental-rate trends
  • Barriers to entry in market
  • Existence of outside professional management
  • Deferred maintenance
  • Quality of record keeping

For the most part, the first 10 or so variables are the most important and will have the largest impact on a borrower’s ability to obtain nonrecourse financing at favorable interest rates and terms. If you are an experienced self-storage operator, you can imagine how a lender might look at each of these items. Following is how some of these variables would look in an “ideal” refinancing borrower profile:

  • NOI coverage of debt service at 1.30:1
  • LTV of 75 percent or less
  • Occupancy at 80 percent or higher
  • Loan size above $2 million
  • Population of 100,000-plus in 15-mile radius
  • 40,000 or more rentable square feet
  • High-quality buildings, security, etc.
  • Good personal credit rating

Even if your profile doesn’t look like this, you can still refinance your current loan. You just may not get the best terms and interest rates. For a recourse loan, the ideal borrower profile would be focused more on the credit worthiness and self-storage experience of the borrower.

Terms for a nonrecourse refinancing will vary, based on where the borrower’s business falls on the above variables. The following table provides an idea of the range you might expect for a 5-year, fixed-rate and 10-year, fixed-rate nonrecourse loan. Again, depending on the individual circumstances, the interest-rate spread (percent over the Treasury index) could be more or less.

Refinancing your self-storage loan does not have to be expensive. Generally speaking, you should plan for between 1.5 percent and 2.0 percent of the loan amount for your overall costs. There are loan programs that will help control these costs by offering fixed fees. These programs usually apply to loans in the $500,000 to $4 million range.

Common Borrower Mistakes

The refinancing process does not have to be complicated or stressful. One way to ensure a smooth process is to learn from others mistakes. Following are some common mistakes to consider before you start.

1. Not considering all available loan products.

The natural tendency for a borrower when it is time to refinance is to use the same loan product from the same source as used in the original loan. By doing so, he may miss an opportunity to find a new product that may be less expensive or better fit his needs. For example, if you typically “roll over” your bank loan at the lender’s maximum term for a fixed rate, generally five years, you may not realize 15-year fixed rate loans are available, often at similar rates.

2. Using an inexperienced attorney.

Using an inexperienced attorney to close your commercial real estate loan could cost you considerable time and money. You should select your attorney based on his experience in closing these particular loans. Commercial real estate brokers are a good source for referrals.

3. Failing to negotiate deal points in the loan-quote letter.

A lender will generally issue a loan-quote letter, which contains all the key aspects of the loan being offered. This is the point in the process to make sure you understand everything in the quote and that any issues are cleared up before proceeding. Once the letter is signed and deposits are made, it will be too late to renegotiate. This is also the point at which you want an experienced attorney involved in the process.

4. Not anticipating the lender’s underwriting adjustments.

Many borrowers are surprised and often disappointed when a lender or loan broker calculates the maximum debt a self-storage business can support at a dollar amount lower than expected. Lenders can and do make adjustments to effective gross income and operating expenses before determining the amount they will lend on your business. The rationale behind this is if they have to take over the property in a default proceeding, they want to ensure they can duplicate operating results until they are able to resell the property. The categories lenders most commonly adjust are vacancy, operating expenses, management fees and reserves. Being aware of these adjustments will prevent you from being disappointed or surprised as you go through the refinancing process.

If you own a facility fortunate enough to be above 95 percent occupied, there’s a good chance you will not get credit for your occupancy in the lender’s valuation analysis unless he can substantiate it by looking at occupancy across the market. Some lenders use a minimum vacancy of 10 percent or the actual vacancy, whichever is greater. The net effect of this adjustment will be to lower your NOI, which will translate to a lower-than-expected loan amount.

The adjustments lenders make to operating expenses are geared toward making them reflect what they might expect if they had to take over the facility and run it themselves. For example, if you have been running your facility at an operating cost of only 20 percent due to lack of payroll, advertising expenditures or third-party management fees, the lender will add these line items into your profit-and-loss statement during the underwriting and loan-sizing process. The net effect reduces your NOI, which in turn reduces your value and, consequently, the amount you can borrow.

The same type of adjustments to operating expenses will be made for reserves for repairs and maintenance. The amount of the reserve is generally determined by an engineering inspection and is based on what the inspector claims is necessary to maintain the property in top condition.

5. Not using an experienced self-storage mortgage broker.

The last of the common mistakes owners make when refinancing is not using an experienced self-storage mortgage broker. Brokers have many lender contacts that know and understand the business. These connections allow them to offer clients a large assortment of loan products geared toward their needs. Because brokers do volume business with lenders, they are also able to get favorable pricing, which is passed on to the borrower. Using a broker can save money, time and headaches during the process.

Whether you are refinancing for the first time or contemplating a refinance for the future, it is important to understand the alternatives and pitfalls involved. If you do your homework and use the expertise of others, you will find the process successful and stress-free.

Bill Walton is a CPA and a vice president of S & W Capital and Realty LLC. He specializes in arranging financing for owners in the self-storage industry. For more information, call 704.371.4275; e-mail bwalton@sandwgroup.com.

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