Facility owner and real estate broker C. William Barnhill did some interesting research on loans he was refinancing for his own account. I asked him to share his findings with our readers.

TRADITIONAL, FIXED-RATE, COMMERCIAL BANK LOANS HAVE BEEN the mainstay for self-storage acquisition and refinancing. Additionally, in some situations, owners elect to seek nonrecourse financing offered through mortgage brokers and insurance companies. These are typically called conduit loans. Other alternative financing solutions are available that offer flexibility as well as the opportunity to take advantage of variable interest rates, with or without a maximum ceiling rate.

The following is a brief interview, conducted by Barnhill, with John Mazyck of Merchant Capital and Paul Oberkirch of Union Planters Bank to discuss alternative financing solutions. One such alternative is taxable, variable-rate demand note (VRDN) financing.

Barnhill: John, would you tell us what a VRDN is and how it makes an effective alternative for some self-storage financing situations?

Mazyck: When financing or refinancing a self-storage facility (or any other real estate investment), a borrower has the choice of taking out a traditional commercial loan or issuing taxable variable-rate demand notes. In a traditional commercial-loan transaction, a bank lends its deposits to the borrower at a spread above LIBOR (London Interbank Offering Rate) or prime. In a VRDN issue, the bank issues its letter of credit for a fee to support the borrower's corporate-debt offering. The VRDNs will bear interest at LIBOR-equivalent rates and may be pre-paid in part or whole with no penalty at any time.

While the interest rate on the VRDNs approximates LIBOR, the effective rate of borrowing is LIBOR plus the cost of the letter of credit (1 percent) and other annual fees, totaling approximately 20 basis points. In today's interest-rate environment, the effective rate calculation of VRDN financing is: LIBOR (1.8 percent) + annual costs (1.20 percent) = 3 percent. LIBOR rates are floating.

Any borrower with a higher cost of capital should give serious consideration to VRDN financing, as it leads to immediate and substantial savings. Financing self-storage projects makes economic sense any time the total principal amount of debt is more than $2 million. Because closing costs are marginally higher than those associated with traditional commercial loans, it makes the most economic sense for larger borrowings.

To access the VRDN market, a borrower (or project) must obtain credit support in the form of an investment-grade letter of credit. It is the institution's job as the borrower's investment banker to secure a letter of credit that meets the desired terms, pricing and conditions of recourse. While the most likely candidate for this letter of credit may be your existing bank, there are a number of banks across the country that are especially interested in the self-storage industry. A cap on the rate can be purchased if one is concerned about rates going higher.

Another less complicated but equally attractive loan type is the variable-rate bank loan with a maximum or ceiling interest rate. The initial interest rate is typically somewhat higher than with VRDNs, but carries the advantage of a reasonable ceiling rate.

Barnhill: Paul, will you tell us about some of the typical self-storage deals you are doing and the advantages of these type loans?

Oberkirch: As most investors are aware, the dramatic decrease in interest rates over the last year and a half has prompted a lot of new commercial-loan activity and refinance activity for banks. Many borrowers have decided to take on new projects due to the lower interest rates, which shorten the payback time of the project.

During this period of interest-rate volatility, there has been a sizeable difference in the pricing of short- and longer-term interest rates from financial institutions. The shorter-term interest rates, such as the prime rate of banks, the treasury bill or LIBOR, have been very attractive to investors, while longer-term rates in the five-year maturity time frame have remained relatively high due to investors concerns over inflation and the expectations of future increases in interest rates.

To take advantage of these refinancing opportunities, some banks have been pricing longer-term real estate loans based on short-term interest rates with a ceiling. For example, an investor with a self-storage project could get a 20-year amortization with a five-year balloon at a floating rate of LIBOR plus an interest-rate spread, usually with a ceiling. The required spread over the pricing index depends on the amount of risk to the bank, but has typically been about 250 to 300 basis points over the 30-day LIBOR rate, which would have an effective rate of about 4.3 percent to 4.8 percent in today's market. In this scenario, the loan and the payment amount could change each month with the fluctuation of interest rates. The typical ceiling for this type of product, depending on the bank, has been anywhere from 7.5 percent to 8 percent.

This type of pricing has been beneficial for both the borrower and the bank. The borrower is able to take advantage of the extremely low short-term rates, which provide lower payments and help provide better cash-flow coverage for relatively new projects. The bank is able to provide floating-rate pricing, which will be important to the bank's return on assets as interest rates start to rise. As an added benefit to the customer, the bank is providing a maximum interest-rate ceiling, which gives the customer confidence about his interest rate risk in the project.

While floating-rate pricing is not for all borrowers, it might be beneficial to consider. The next time you ask for a loan commitment from a financial institution, ask it to offer you both fixed and floating interest-rate options. If you do not feel knowledgeable about the pricing index your institution offers you, do not hesitate to ask your lender for a 10-year history of the pricing index to give you comfort about this floating-rate option.

Both the above financing solutions provide substantial interest savings. With interest rates at a 32-year low, it makes economic sense to take advantage of this exceptional opportunity to refinance. The following chart illustrates the interest-cost savings obtained by refinancing with a five-year maturity, 20-year amortization loan at 7.5 percent.

The current annualized interest savings of $77,145 to $105,420 can be applied to principal or used as spendable income. Obviously, the longer rates remain low the greater the cost savings. The ceiling rate of 7.75 percent ensures the monthly payment would never exceed $28,733 during the term of the loan.

The type of financing a person chooses depends on one's tolerance for interest-rate risk and whether one is willing to be personally liable on the loan. The above loan types--or variations of them--have been used in our area as effective financing alternatives. The obvious advantages are the lower interest rates with enhanced flexibility to accommodate a typical refinancing and acquisition or new construction financing.

Michael L. McCune has been actively involved in commerical real estate throughout the United States for more than 20 years. Since 1984, he has been owner and president of Argus Real Estate Inc., a real estate consulting, brokerage and development company based in Denver. In January 1994, he created the Argus Self Storage Real Estate Network, now the nation's largest network of independent commercial real estate brokers dedicated to the buying and selling of self-storage facilities. For more information, call 800.55.STORE or visit www.argus-realestate.com.

CONTACT INFORMATION

C. William Barnhill
Omega Properties Inc.
888.801.4534
[email protected]

John Mazyck
Merchant Capital
334.834.5100
[email protected]

Paul Oberkirch
Union Planters Bank
251.473.0596
[email protected]