In the past four years, it seems loans for construction financing have been on the edge of extinction. Such loans became unpopular due to the recession and the sudden over abundance of self-storage properties in certain markets, many of which have had lower than projected rents and disappointing lease-up velocity.
Between 2007 and 2011, it was not uncommon to see lease-up plateauing between 40 percent and 60 percent for some newly constructed properties. Coupled with leverage that, in some cases, exceeded 80 percent, plus the high cost of land, many lenders ended up being responsible for distressed loans and real estate-owned properties that sold well below the original loan amount. This made lenders leery of giving construction loans. Today, this once-flourishing loan type can certainly be considered an endangered species.
Fortunately, in the past year, there has been a glimmer of hope for those seeking to secure construction loans for self-storage. There are lenders familiar with the storage industry who know that just because one market is overbuilt or has had bad luck doesn’t mean another market isn’t in need of new supply. By knowing where and how to apply for a loan, as well as some of the particular considerations for self-storage construction lending, you can take these loans off the endangered-species list.
The Structure of a Loan: Some Things to Know
There are several terms you must first understand when it comes to construction financing. They include the following:
Term. One of the major lessons learned by borrowers over the last downturn in the cycle was to make sure you have a sufficient cushion in your loan term to allow for slower than anticipated leaseup. Prior to the market crash in 2008, many construction loans had a term of 36 months. However, due to a slowing economy, many facilities were not stabilized at the end of the loan term, leaving the borrower and the bank in a precarious position. To avoid this, I suggest negotiating a four- to five-year term with a few one-year extensions.
Rate. Interest rates are at historically low levels. For variable-rate loans, we’re currently seeing spreads between 275 and 450 basis points over the 30-day London Interbank Offered Rate (LIBOR) and -50 to 150 basis points over Prime, a rate of 3 percent to 5.5 percent. On a fixed-rate loan, active construction lenders are offering three- to five- year fixed rates between 4 percent and 7 percent. The low interest-rate environment makes this a very attractive time to develop, as it reduces the overall cost of construction.
Loan to cost (LTC). The LTC constraint is fluctuating between 50 percent to 80 percent, depending on the transaction specifics. The LTC is dependent on the bank, the strength of the borrower and the quality of the property. A strong borrower with a short track record in self-storage and a reasonable project may be required to contribute as much as 50 percent of the project cost in cash, whereas a strong borrower with a long track record and an excellent project, who bought the land or conversion property at the “right price” or below market, may be able to achieve 80 percent LTC. Higher LTC loans are also more easily achieved when the delta between the construction capitalization (cap) rate and the residual cap rate is larger.
Interest-only and interest reserve. Most construction loans today are still interest-only or have a period of interest-only. Interest-only refers to what’s included in the payments made to the bank during the term. Because there’s no cash flow during the construction period and cash flow is very tight during leaseup, banks will allow the borrower to pay only the interest due and not require any paydown of the principle loan amount.
Additionally, banks will create an interest reserve, which essentially allows the borrower to borrow the funds needed to make the monthly interest payments, which is extremely helpful during the construction process. If no interest reserve is set up when the loan is negotiated, interest payments need to be made out of the borrower’s pocket. It’s important to negotiate a large enough interest reserve to take you through leaseup and give you a bit of a cushion in case of construction delays or slower than anticipated leaseup.