It’s no secret the recession has impacted owners and investors of all types of commercial property, self-storage included. From institutional property owners like publicly traded real estate investment trusts (REITs) to individual investors, it’s hard to escape the stark reality that primary operating fundamentals such as rental rates and occupancy are being challenged. In addition, cap rates are rising, and the entire financing paradigm has changed dramatically.
The combined effect of these market and economic forces can create new and sometimes unanticipated challenges for property owners. In some cases, it may not be readily apparent that a property is an under performer. Sure, rents and occupancy are down a bit, and concessions are more prevalent than a few years back, but that’s not unusual given the current economy. As long as there’s still cash flow to service the debt, there’s not really anything to worry about. Correct? Well, not exactly.
Properties with cash flow adequate to service existing debt but facing near-term loan maturities may have problems lurking in the distance. The new lending paradigm dictates much lower available leverage (65 percent) and more conservative underwriting than what was prevalent in the recent past. Couple this with valuation changes resulting from cap-rate expansion, and the result is many transactions are over leveraged by current standards.
Recognize the Problem, Calculate the Debt Yield
To determine if your loan is over leveraged, you can quickly calculate the debt yield to gain a more thorough understanding of the situation. To complete this analysis, simply divide the current loan balance by the net operating income (NOI), which is revenue minus expenses, not including debt service or depreciation. The result is the debt yield. If this number is lower than 12 percent, it’s a strong indication the current debt is higher than what’s available in today’s financing market.
Debt yields are a useful proxy measure and have been around forever. They provide a historical data set spanning multiple recessionary periods that lenders can reference and rely on. In a market where critical inputs such as underwriting standards, loan constants and cap rates change over time, debt yields are a constant that provide a useful benchmark for the amount of debt historically available for a given dollar of cash flow.
Historically, debt yields have rarely dipped below 12 percent. The last several years when capital was flowing freely and aggressively were clearly the exception and not the norm.
Think Like a Lender
To derive a valid cash-flow number, put on your lending hat and use a bank underwriting methodology that includes the following:
- Market vacancy: A realistic market vacancy of no less than 10 percent.
- Management fee: Even if you do not have one, you must include one that is generally between 3 percent and 6 percent of effective gross income.
- Taxes and insurance: Use current premiums (not last year’s figures).
- Payroll: A realistic payroll number, regardless of whether your facility is self-operated.
- Replacement reserve: Typically 10 cents per square foot.
The operating-expense ratio should be in the 30 percent to 40 percent range. To calculate this, divide the sum of your total operating expenses by your income. If the number is a lot less than 30 percent, it’s probably not a realistic estimate of what it would cost a third party to operate the facility. Alternatively, if it’s much higher than 40 percent, a careful analysis may identify some capital-intensive or one-time expenses that can potentially be identified for the lender, footnoted and removed from the analysis.
If your loan is coming due in the near future, you should also calculate the exit debt yield. Simply use the loan balance that will be outstanding when the loan comes due. This is highly relevant because amortization will result in principal pay-down over a couple years, and the debt yield today will obviously be lower than when you refinance the loan.