The Decision: What Else are Banks Looking For?
The financial strength of the borrower is as important as the feasibility of the project. Construction loans require a full guarantee from the owners of the borrowing entity. In the industry, this is commonly known as a full-recourse loan. As construction loans come back from extinction, it seems only the strongest borrowers are getting financing. Lenders consider a borrower’s net worth, liquidity and global cash flow to determine if the borrower has the financial strength to pay down the loan.
Another important consideration for banks is the borrower’s experience in developing successful self-storage locations. In my experience, it seems only the most seasoned developers have been able to access construction financing. However, based on the bank, the borrower’s relationship with the bank, financial strength and the merits of the development, a bank may be willing to work with less experienced developers. Your relationship with your local bank can work in your favor here, as can a strong and compelling feasibility study.
Another consideration is the pro forma, the actual number crunching. Credit officers at banks are numbers guys, so an important part of any potential transaction is the financial projections that support the project. A pro forma should detail anticipated revenue and expenses on a monthly basis from the completion of construction through leaseup.
It’s imperative you demonstrate a strong understanding of the economics behind the asset class (multi-family differs from industrial, which differs from self-storage, etc.). You need to demonstrate the project will be profitable, there will be sufficient income to pay the mortgage, and leaseup is fast enough to replace the construction loan with a permanent loan prior to the end of the construction-loan term.
Improvement in the permanent market is one factor that’s bringing construction lending back from the edge of extinction. When the capital markets were at a standstill, construction lenders were hesitant to make loans because they didn’t know what the exit strategy would be. The improved permanent market has alleviated this concern. The lender is going to want to see that the project is profitable enough to support a permanent loan greater than the amount of the construction loan.
When creating your pro forma, it’s important to be realistic with your projections. If you’re too aggressive with the leaseup rate or your expenses are too low because you’re trying to be optimistic, you’ll give the appearance that you don’t understand the industry. It’s also important to include different financial scenarios, including an expected case, an upside case and a downside case. Make sure that even in the downside scenario there’s a strategy to pay off the construction loan. All of your projections must be supported by the feasibility study.
Lastly, consider your management group. Now more than ever banks are concerned about the management of the proposed facility. Management groups have received heightened scrutiny due to the number of transactions that have stalled prior to projected stabilization over the last few years. This has largely been due to a lack of experience or a misunderstanding of project scale.
In the bank’s eyes, an outside management firm is preferable unless the borrower has a significant track record in self-storage management. Hiring a third-party management firm gives the bank confidence that the people running the day-to-day operations have sufficient experience, thus mitigating a major risk.
It’s a Great Time to Develop
Despite the difficulties, the endangered construction loan is ready to flourish. There has been virtually no development over the last three years in the self-storage industry, so many investors are looking to development as a way to grow their portfolio. Because of the lack of development, we’ve seen a better balance of supply and demand in many submarkets.
Additionally, inputs are cheap, as vendors are trying to put their people to work and move product. Combined with the low interest-rate environment, the aggressive cap rates for stabilized facilities, and the upward pressure on rates in certain markets, self-storage construction loans stand to make a comeback from being an endangered species to being a thriving opportunity for self-storage developers.
Devin Huber is a principal at The BSC Group, which offers financial and loan advisory, mortgage-brokerage and loan-workout solutions to commercial real estate property owners and investors, with a special emphasis on the self-storage market. Prior to helping found The BSC Group, Huber was a senior vice president at Beacon Realty Capital and a key member of the firm’s Self Storage Group. To reach him, call 800.605.7880; e-mail firstname.lastname@example.org; visit www.thebscgroup.com.