Let’s start with the future. Almost all financing decisions are based on expectations. Do you expect to sell your property any time soon, or do you plan to hold it for the long term? Will your net operating income increase significantly, or have you reached stabilization? Will interest rates rise or fall? These are just some of the questions you need to ask yourself as you look at the financing alternatives available in today’s marketplace.
Loan types fall into four basic categories: construction, bridge (also known as interim), permanent and mezzanine. Let’s look at each loan type and the role it plays in self-storage.
The easiest test to determine if you need a construction loan is to look at your self-storage site. If you don’t see any units, there’s a good chance you need a construction loan! There are no real viable options unless you have the money to build the project yourself. In simple terms, the construction loan provides you the debt capital to acquire a plot of land and develop a storage facility on it. While all construction loans accomplish the same thing, they’re not all the same. In fact, every loan is unique.
The great majority of construction loans are provided by commercial banks and thrifts. But in recent years, some of the Wall Street-based lenders and life-insurance companies have entered the loan market, often combining construction and permanent financing into a single transaction (usually for larger deals). Shop alternatives, and pay attention to detail. Items that appear trivial or meaningless during the loan process may prove to be important later in the project.
A bridge, or interim, loan is usually a floating-rate loan offered for a short term, usually one to three years, with very liberal prepayment terms. Bridge loans may require personal guarantees, but some are nonrecourse. The choice between bridge and permanent financing involves a careful analysis of where your project stands now, and how successful you believe it will be in the future. Let’s look at some scenarios in which bridge financing may be the smart choice:
A bridge loan may be your best alternative if you are acquiring a property that has not yet reached the occupancy or income level you desire, or an older property with a volatile operating history. Why? The primary benefit of a bridge loan is flexibility. A bridge loan allows you to wait until a property has reached its highest possible net operating income before making the long-term commitment to permanent financing. This is especially important if you’re aiming to maximize the size of your loan.
To sell or not to sell?
Some owners have a very clear plan for the future of their property, while others do not. If you don’t have a clear plan, or if your plan involves the sale of the property, a bridge loan may be your best bet.
Many income properties are sold with permanent financing in place, with the buyer assuming the existing loan. But most experts will tell you that allowing a buyer the flexibility to make his own financing decisions is a real benefit when you’re trying to sell a facility. This can be especially true if your property has appreciated and your loan has a much lower loan-to-value ratio than it did when you made the purchase. In this case, the assumption of your existing loan may require a bigger down payment than a buyer is willing to make.
The interest rate on an assumed permanent loan will impact the sales price. If your rate is deemed to be above market at the time of the sale, you can expect at least a slight discount in the offering price because of it.
I just can’t get permanent fixed-rate financing!
There are many reasons a borrower may find it difficult to obtain a permanent loan. He may have had credit or bankruptcy problems. His financial strength may not be up to par when compared to the loan amount he is requesting. Or he may have had a bad experience with a lender in the past that resulted in a negative reference. In any case, the passage of time will most likely be to the borrower’s benefit, and a bridge loan is very good way to buy time. He will almost certainly have to provide personal recourse to his lender, but that’s palatable when the alternative is no financing at all.
The very broad category of bridge financing incorporates many types of loans and lenders. The most common providers are commercial banks and thrifts, but nearly every lender has a product aimed at satisfying the bridge-loan borrower.
Many life-insurance companies and Wall Street lenders have a strong appetite for large bridge loans, and offer them with the hope of eventually providing the permanent financing that will follow. “Hard money” lenders (usually private parties) provide high loan-to-cost or loan-to-value bridge loans at higher interest rates and sometimes also take an ownership interest. In purchase transactions, bridge financing is often provided by the seller of the property. If you decide a bridge loan may be your best choice, check with your mortgage banker to assess the alternatives in your market.
Permanent loans are traditional fixed-rate mortgages, with terms as short as five years or as long as 30 years. Over the past decade, the 10-year loan term has become the most prevalent.
Permanent loans differ from bridge loans in two primary areas. First, permanent loans generally have fixed interest rates—and, thus, fixed monthly payments—in effect for the entire loan term. This can be of tremendous benefit to a borrower, especially if the loan is obtained in a low-rate environment. A property owner is wise to fix his most significant expense item, as it essentially increases the performance of his property. Offsetting this benefit is the second primary difference between bridge and permanent loans: prepayment penalties. In most cases, a lender’s willingness to provide a long-term, fixed-rate loan is contingent upon a guarantee that it will receive interest for the entire loan term. To ensure this, lenders charge penalties if a loan is paid before its maturity.
These penalties can be structured in an infinite number of ways. They can be a stated fixed percentage of the loan amount, or they can be derived from a formula aimed at providing the lender the exact same return it would have received if the loan had gone to term. In most cases, any permanent loan paid two years or more before scheduled maturity is going to have significant penalties.
How do you know if the time is right for a permanent loan? You’ll ask yourself the same questions posed in regard to bridge loans, but this time, you’ll be looking for different answers.
Is the property stable?
If you’ve reached a occupancy level in keeping with the surrounding market, you can consider your property to be stable. This doesn’t mean your income won’t improve, it just means increases will be primarily driven by changes in rental rates, not occupancy. A stable property is a good candidate for permanent financing.
Are you a long-term holder or a potential seller?
What’s your game plan? If you expect to sell your property in the foreseeable future, you may be better served by a bridge loan. But if you plan to keep the property indefinitely, it’s a good idea to lock into a long-term interest rate that will fix your costs.
What if you just don’t know what the future holds? If you have a permanent loan and eventually decide to sell, a buyer can usually assume your existing loan, helping you avoid prepayment penalties. The terms, amount and interest rate of the loan will all be factors in whether a buyer is willing to do this.
Are interest rates going up, going down or remaining stable?
If you really knew the answer to this question, you’d be a billionaire. All we common folk have to help us predict interest-rate trends is history. And in the financial market, history doesn’t always repeat itself. In the end, it boils down to what you think will happen with rates and how they relate to your personal investment strategy.
If current fixed rates don’t allow for the return you desire, and you’re convinced they will drop in the future, a bridge loan with a floating rate might be the best choice. On the other hand, if fixed rates are favorable to your investment goals, you should probably lock in a rate as soon as possible. Your lender or mortgage banker can offer his opinions, but the final decision rests with you.
In almost every type of commercial real estate, the largest single expense of ownership is the debt service on financing. Owners may find it prudent to fix that expense, even if the interest rate isn’t the lowest ever offered.
So now that you’ve asked yourself all the important questions and chosen between bridge and permanent financing, the decision process is over, right? Maybe not. Would you like to borrow more money than your lender is willing to give you?
Over the past five years, a previously rare loan product has worked its way into mainstream commercial lending. A mezzanine loan allows you to borrow an extra 5 percent to 10 percent in excess of the amount a traditional mortgage lender will normally allow (based on property value). Sometimes these loans are secured by a second mortgage; other times, they’re secured by a pledge of ownership interest in the property.
In most cases, mezzanine loans have interest rates more than double those on first mortgages. For this reason, they are primarily used during acquisition, attached to loans of $4 million or higher. They are rarely used for refinancing.
When deciding on financing, keep in mind your ultimate goal. Are you looking to build a property? Are you trying to fix costs for a stabilized property or obtain permanent financing for long-term debt? Are you seeking short-term options to get you through to a sale? Whatever your aim, today’s low interest rates make it a good time to seek financing. Evaluate your alternatives, and make the best choice for your business and future.
Tom Walsh is a director for Collateral Mortgage Capital LLC and office manager of the company’s Atlanta commercial loan-origination office. He has worked in commercial real estate finance for 20 years. Collateral is a national mortgage-banking firm founded in 1933. It represents several national and local institutional loan sources that serve the self-storage industry. For more information, call 770.817.1600; visit www.collateral.com.