Fixed-rate mortgages, which are based on Treasury yields plus a spread, have begun to rise. If you aim to reduce your interest rates and are currently paying more than 6.5 percent on a fixed-rate basis, consider refinancing. If you have a variable-rate mortgage, though it may be difficult to give up interest rates in some casesbelow 3 percent, you need to consider your market volatility risk and exposure to increased future interest rates.
Despite the economy and other perceived negative factors, there is still an abundance of capital chasing real estate transactions. A case can be made that the self-storage industry is less affected by economic downturns than other real estate investments, because regardless of the economic cycle, people and businesses still need a place to store their belongings, inventory and records.
Keeping this in mind, it is not unreasonable to expect lenders will continue to provide capital to the industry. It should be noted, however, that those owners with newer properties, larger and well maintained properties, and a proven operating history, will likely find it easier and less expensive to obtain better financing arrangements than those who are performing at average or below-average levels.
Periodically, you should review and evaluate your financial structure. This review should entail:
- Looking at your current debt structure vs. available financing in the current market.
- Reviewing the potential upside or downside in refinancing at a later date.
- Assessing your propertys strengths and weaknesses relative to current and future competitors.
- Evaluating the anticipated neighborhood demographic trends.
When should you refinance, and how much can you borrow?
Refinancing is one of the few nontaxable events through which you can access cash without paying taxes! You can use the cash proceeds to pay off partners and reorganize your ownership structure, provide seed money for your next development project, expand your existing facility, acquire another property, or simply have more cash on hand and more liquidity on your balance sheet.
The primary reasons to refinance your property include:
- Paying-off a construction loan.
- Refinance a maturing loan.
- Increasing leverage and thus recap initial investment equity.
- Expanding your facility.
- Reducing or eliminating recourse.
- Lengthening the amortization term (thus reducing monthly debt payments).
- Reducing your interest rate.
- Lengthening your loan term, and/or to lock into a fixed rate.
The question invariably arises as to when is the right time to refinance. If you are seeking to optimize your loan, it is advisable to wait until the property reaches 85 percent to 95 percent of physical occupancy, and 80 percent to 85 percent of economic occupancy based on current asking rents. Lenders generally calculate income on a trailing 12-month basis. With a compelling, steadily increasing historic revenue pattern, aggressive lenders will use the most recent months to determine the loan size.
A loan amount is typically derived from the lower of maximum loan-to-value (LTV) or minimum debt-service coverage (DSC). As a guideline, it is reasonable to assume you can achieve a loan with a maximum of 75 percent of appraised value and a minimum DSC of 1.25 to 1.35. There will be lenders with more aggressive terms, while others will offer more conservative ones.
A refinance can lead to one of the great benefits of owning self-storage by rewarding you with cash in excess of current debt and, in many instances, of original cost. From a lenders perspective, however, large cash out can mean increased scrutiny and the potential to cut loan dollars, thereby reducing some of the risk in the transaction.
Lenders are getting more conservative. If you are seeking to recover your 100 percent of the initial cash investment or more, essentially removing your equity from the deal, the lender will definitely need to get comfortable with the historic cash flow, as well as your propertys ability to maintain its value. Some lenders will limit loans to a certain percentage of costs. Others will refinance your property up to 80 percent of current value. Keep in mind, the longer you own your property, the less likely it is for a lender to look at your cost basis as a constraint on a refinance.
Because of the low interest-rate environment, a loan will usually be limited to the maximum LTV allowed by your lender. Again, opportunity is knocking. Property values have generally increased. This is not a trend that is new from previous years, but the reason for property appreciation is.
The industry has had a consistent trackrecord of high occupancies and increasing rental income. For the first time for some owners, the local or regional demand/market softened, causing occupancies to decline and the ability to maintainlet alone increase rental income to be a challenge. However, because of a combination of factorsmainly the reduction of interest rates and the investors desire to invest in real estate vs.stock and bondscap rates for real estate including self-storage has decreased, thus increasing property value (assuming the operating income has remained the same).
The value of your property must also be verified by an appraiser hired by the lender. An appraiser mainly looks at the physical attributes of the propertyits location, market and operating incometo conclude a market value.
According to a recent appraisal prepared by Ray Wilson, president of Charles R. Wilson & Associates Inc., there has been a trending downward of capitalization (cap) rates for the past two to three years, which reflects the increased demand for this property type and more favorable lending rates. The research indicates trailing (based on historic operating performance) cap rates may be 9.5 percent or less, with the typical investor looking for a reasonable opportunity to increase income. Note that facilities not considered investment grade have cap rates anywhere from .75 percent to 3 percent higher than the above-stated.
Lenders lend on past performance, paying careful attention to whether it is likely you will be able to sustain or improve your operating performance in the future. Have you been able to maintain or improve your occupancy? Has your competition been able to maintain or improve its occupancy?
These questions are very important, because the lender will analyze the current market occupancy to determine the occupancy that will be used for underwriting. If the general market has shown softening and vacancies are increasing, lenders will likely be more conservative in their underwriting. In certain circumstances, a shrewd operator can demonstrate that although physical occupancy has declined or remained steady, income has risen. Often, good management can offset physical occupancy by increasing unit sizes that are more in demand or controlling expenses.
Competition always has an impact. The newer properties are often being built at prime locations with more bells and whistles. There are other properties in locations that really dont have the right characteristics for additional storage. Whatever the case, the competition in a market place represents a choice to the consumer. It creates a spectrum of amenities and prices. It is the owners and managers job to understand the market in which they compete and sell based on the attributes important to the customer base they are targeting.
Because of the cost differential of older vs. newer properties, there is a spectrum of pricing in most markets for the same size unit. Facilities with different attributes can be effective at finding renters and, more important, can achieve adequate profitability. Your market position must be explained to your lender.
Ownership qualifications are also extremely important.
It is essential to remember the property and its operations do not stand on their own. Like any good marriage, one half complements the other in terms of providing strength. It is, therefore, key to highlight your management capabilities. A sound net worth and a reasonable amount of liquid assets, in comparison to the loan request, will be evaluated in a positive manner. Whether the loan is recourse or nonrecourse, lenders like the assurance that the borrowers behind the project have the resources and wherewithal to withstand downturns or unexpected negative events.
Should you elect to refinance using a variable-or fixed-rate loan?
If you intend to make another financing decision within one to three years, variablerate loans are most likely an option for you. However, if you plan to hold on to your property and it has stabilized operations (a history of approximately 85 percent-plus occupancy), you should consider locking into a fixed-rate loan for, at minimum, the time you plan to own the property.
There are three-, five-, seven-, 10-, 15- and even 20-year fixed-rate terms available. But they frequently come with a catch: They often have prepayment provisions. These provisions may not allow you to prepay for a period of time followed by a defeasance period, whereby you essentially guarantee the interest rate you signed up at is going to be paid for the remaining period of the loan, regardless if you pay off the loan. A new owner can assume most fixed-rate loans for the maximum of a 1 percent fee. In todays low interest-rate environment, a long-term low-interest loan may add additional value to your property should interest rates rise.
Variable-rate mortgages are often based on the Prime rate or LIBOR (London Inter Bank Offered Rate) plus a spread. At the time of this writing, these rates are abnormally low. The natural instinct is to wait to refinance until those rates start to rise. The risk you must weigh is that these variable-rate loans are based on different indices than longer-term fixed-rate loans.
Short- and long-term indices rarely move parallel to each other. In fact, in July and August, while the Prime rate had decreased .25 percent to 4 percent and remained there, the 10-year Treasury rose from 3.22 to 4.56 percent in less than a 60-day period. The steep, sudden rise in long-term rates often goes unnoticed by the owner community, because it doesnt follow the daily fluctuations of interest rates as a course of its daily business.
What lenders should you seek to refinance your property?
The majority of todays self-storage financing is obtained through banks and conduits. When deciding which lender to use, the logical first step is to speak with your current lender. He is going to know your credit history the best, and if he can offer you a competitive quote, will most likely be the easiest to deal with at the lowest cost. However, lenders often change their appetite and desire to lend. Sometimes the bank that provided the construction financing does not offer competitive refinancing alternatives.
If you choose to go out to the lending community to refinance your property, select lenders who will be able to provide you the service you deserve. For example, it is not advisable to go to a lender who will focus on deals significantly larger or smaller than your transaction.
Most national lenders, specifically those who offer conduit loans, will usually avoid making loans less than $1 million. In fact, the minimum loan size for conduit lenders is often $2 million to $2.5 million. There are, however, several conduit lenders who will focus on smaller loans through their small- or microloan programs. The loan size for most of these programs is between $1 million and $3 million. Local banks desire to lend on selfstorage is all across the spectrum. Some will be extremely aggressive, while others will not even look at your financing-request package.
Banks are mostly portfolio lenders, meaning they will retain the loan as an asset on their balance sheet. Accordingly, a portfolio lender may offer more flexibility with loan terms than would a securitized lender, who will typically sell the loan after making it. It is important to ask the lender/banker whether he intends to keep your loan on his books, sell the loan or securitize the loan. If the lender intends to sell or securitize, he may have limited flexibility.
Depending on the lending institution, maximum loan-to-value (LTV) ratios vary from 65 percent to 80 percent. Although some banks will lend up to 80 percent LTV, in recent years, it is has become much more common to see quotes in the 70 percent to 75 percent range. Furthermore, many banks now limit the loan to a percentage of your initial cost (loan-to-cost ratio, or LTC), thus requiring you still have some portion of your initial investment, or true equity, in the deal. Although some banks will amortize a selfstorage facility on a 25- or even 30-year schedule, it is much more common to see a 20-year amortization quoted.
Terms for bank loans range from one to 20 years. However, it is unusual to see banks loans being fixed for more than a five-year period. Fixed-rate loans generally have prepayment penalties associated with them, whereby the borrower pays a penalty for paying off the loan early.
Many banks require recourse. Some lenders will reduce or eliminate the recourse as a percentage of the loan if certain operating- income hurdles are maintained. Given the right set of qualifications, such as a low LTV, some portfolio lenders will provide nonrecourse financing.
Conduit loans are a specific type of loan that can be made by a bank, credit company, life-insurance company or Wall Street firm. These loans are unique because, unlike portfolio loans, which are held by the bank as assets, conduit loans are originated with the intention of being pooled and sold as mortgage backed securities, hence the name conduit.
The bonds backed by the pool of mortgages are sold as debt instruments called commercial mortgage-backed securities (CMBS) on Wall Street to institutional type investors, who prefer the diversification of risk these securities offer. CMBS are examined by Wall Street bond-rating agencies, such as Standard & Poors or Moodys Investor Service, where they are rated and prioritized according to the likelihood of default.
Owners looking for long-term fixed-rate financingand who do not intend to pay their loan off earlymay prefer conduit loans. This type of financing has been a popular option in the recent interest-rate environment. A typical conduit loan has a fixed interest rate, 10-year term and 25-year amortization period. The LTV does not exceed 75 percent, and DSC is 1.25 to 1.35. There is also a rating-agency stress test a lender will need to meet that may further limit the loan amount. Conduit loans are nonrecourse, meaning they are not secured by other assets the borrower owns.
There are some drawbacks to conduit loans. Because all of the loans pooled must have similar structures, conduit lenders have very little flexibility when negotiating the terms of a loan. Also, bondholders are expecting a fixed future cash flow from the pool of loans. Accordingly, prepayment penalties on conduit loans are designed to guarantee the bondholders payment of the note rate for the duration of the term. It should be noted, however, that conduit loans are assumable to a future buyer of the property (acceptable to the lender) for a 1 percent fee. Finally, additional funding is not allowable and, therefore, may not be the optimal financing alternative if the facility has additional phases of construction to be built and leased-up.
A mortgage broker is not a lender, but instead works for the owner to arrange the financing. Essentially, the owner looks to the mortgage broker to develop a financing request package and market the request to various lenders. The industry publications list several qualified mortgage brokers who represent self-storage owners.
Is Opportunity Knocking?
In most instances, your mortgage is your largest cash outlay. Your financing expense (interest paid by you) compared with your competitors is going to affect the flexibility to keep rental rates competitive and profitable. As long as mortgage rates are volatile, there will not be an even playing field relating to the cost of your operations. Interest rates are hovering near historic bottoms. This could turn out to be an advantage or disadvantage to your business.
Neal Gussis is a principal at Beacon Realty Capital Inc., a financial services firm that arranges debt for self-storage and other commercial real estate owners. He has been actively involved in financing self-storage properties since 1990. He also serves on the Self Storage Association regional board of directors for the Central region. Mr. Gussis can be reached at 312.207.8240 or [email protected].