It’s no secret the recession has impacted owners and investors of all types of commercial property, self-storage included. From institutional property owners like publicly traded real estate investment trusts (REITs) to individual investors, it’s hard to escape the stark reality that primary operating fundamentals such as rental rates and occupancy are being challenged. In addition, cap rates are rising, and the entire financing paradigm has changed dramatically.
The combined effect of these market and economic forces can create new and sometimes unanticipated challenges for property owners. In some cases, it may not be readily apparent that a property is an under performer. Sure, rents and occupancy are down a bit, and concessions are more prevalent than a few years back, but that’s not unusual given the current economy. As long as there’s still cash flow to service the debt, there’s not really anything to worry about. Correct? Well, not exactly.
Properties with cash flow adequate to service existing debt but facing near-term loan maturities may have problems lurking in the distance. The new lending paradigm dictates much lower available leverage (65 percent) and more conservative underwriting than what was prevalent in the recent past. Couple this with valuation changes resulting from cap-rate expansion, and the result is many transactions are over leveraged by current standards.
Recognize the Problem, Calculate the Debt Yield
To determine if your loan is over leveraged, you can quickly calculate the debt yield to gain a more thorough understanding of the situation. To complete this analysis, simply divide the current loan balance by the net operating income (NOI), which is revenue minus expenses, not including debt service or depreciation. The result is the debt yield. If this number is lower than 12 percent, it’s a strong indication the current debt is higher than what’s available in today’s financing market.
Debt yields are a useful proxy measure and have been around forever. They provide a historical data set spanning multiple recessionary periods that lenders can reference and rely on. In a market where critical inputs such as underwriting standards, loan constants and cap rates change over time, debt yields are a constant that provide a useful benchmark for the amount of debt historically available for a given dollar of cash flow.
Historically, debt yields have rarely dipped below 12 percent. The last several years when capital was flowing freely and aggressively were clearly the exception and not the norm.
Think Like a Lender
To derive a valid cash-flow number, put on your lending hat and use a bank underwriting methodology that includes the following:
- Market vacancy: A realistic market vacancy of no less than 10 percent.
- Management fee: Even if you do not have one, you must include one that is generally between 3 percent and 6 percent of effective gross income.
- Taxes and insurance: Use current premiums (not last year’s figures).
- Payroll: A realistic payroll number, regardless of whether your facility is self-operated.
- Replacement reserve: Typically 10 cents per square foot.
The operating-expense ratio should be in the 30 percent to 40 percent range. To calculate this, divide the sum of your total operating expenses by your income. If the number is a lot less than 30 percent, it’s probably not a realistic estimate of what it would cost a third party to operate the facility. Alternatively, if it’s much higher than 40 percent, a careful analysis may identify some capital-intensive or one-time expenses that can potentially be identified for the lender, footnoted and removed from the analysis.
If your loan is coming due in the near future, you should also calculate the exit debt yield. Simply use the loan balance that will be outstanding when the loan comes due. This is highly relevant because amortization will result in principal pay-down over a couple years, and the debt yield today will obviously be lower than when you refinance the loan.
Anticipate the Future
As mentioned earlier, if the debt yield is less than 12 percent, there’s a good chance the deal may be over leveraged by current standards, meaning the debt will need to be paid down to get a new loan that meets current underwriting parameters. Although debt yield is a useful measure, it’s also critical to understand that when you refinance, the asset will be subject to a new appraisal, and the property value may have declined. Couple this with the lower loan-to-value ratios available to investors today, and there’s a strong possibility you may have a significant cash requirement to close.
If you’re an investor in this position, here are some proactive steps you can take to help make the best of a sticky situation.
Scrutinize your operating expenses. The old guideline in finance is that every $10,000 reduction in operating expenses will bring $100,000 in value to the bottom line using a 10 percent cap rate (for easy math). While it’s not advisable to cut expenses in areas critical to your business operation, always examine discretionary items. Recognize that these add up and impact bottom-line cash flow, and by corollary, your property’s valuation.
Reserve cash. If you believe there’s an equity gap, immediately begin reserving some excess cash flow from operation. Problem-solving can cost money, and if you’re forced to go to the market and respond to an equity gap upon refinance or sale, this strategy should provide at least some cash to help fill it.
Be proactive with your current lender. It’s crucial to contact your lender as soon as possible to discuss modifying or extending the current loan. In this market, it pays to be proactive and leave plenty of time to fully explore your options. Meeting your lender allows you to gauge his reaction and better understand available options. If successful, being proactive may allow for a workable solution that’s much better than being forced to sell or refinance with another lender.
Do your homework. Prior to contacting your lender, do your homework and arm yourself with relevant information. Talk with a qualified self-storage broker to better understand the property’s value and determine if selling is viable. In addition, a mortgage professional can give you a valuable underwriting opinion and identify potential refinancing alternatives. This proactive approach can demonstrate to the lender that a loan modification is the best scenario for all parties involved. After all, the incumbent lender is a partner in the current transaction.
Work With Your Lender
If your property has adequate cash flow to service its existing debt but still faces the possibility of a loan default and subsequent foreclosure, remember the loan’s non-performance is more likely due to current market conditions than the property itself or its owner/manager. Foreclosure is an expensive process for lenders, and they certainly don’t want to be property owners. If the underlying weakness is due to market conditions and not mismanagement, the lender may determine that the most economical solution is to modify loan terms with the existing owner rather than foreclose and be forced to manage or sell bank-owned real estate in a depressed market.
Some assets don’t even generate sufficient cash flow to cover the existing debt. New construction or expansion properties that are not meeting their pro forma income and occupancy projections, for example, may face significant hurdles due to weak demand and softening rent. Likewise, properties acquired or built in the last three years (during the market’s peak) with short-term, high-leverage debt are likely to be more affected by today’s conservative cap rates and debt terms.
The sad reality is the value of many troubled assets is below the existing loan balance. Whereas cash-flowing properties with near-term maturities may face an equity gap, a more severe classification of under performing assets likely has no remaining equity at all.
If you find yourself in the unfortunate situation where the loan balance is greater than the property’s value, you may be facing an uphill battle, but all is not lost. In this scenario, you are likely headed for a workout with your lender. If so, in addition to the steps outlined earlier, consider these additional strategies.
Gather all your loan documents and review them. Make sure you have a good understanding of their contents. In addition, seek competent advisors to guide you. Regardless of the type of loan you have, it’s likely you will benefit from the services of competent legal counsel.
Depending on your loan type, you may also need a loan-workout advisory service. These advisors will cost some money but should help minimize the long-term damage. It goes without saying that all consultants are not equal, so check references and make sure you hire competent and experienced advisors.
Financial-Term Modification Options
Ask for an interest-rate reduction or, if the loan can be converted to interest-only, ask to lower the loan payments to a level that allows the property’s existing cash flow to service the debt. Although it may seem nonsensical that a lender would consider these requests, make the case that he stands to lose less money through this structure than other alternatives such as foreclosure.
See if you can extend the loan’s maturity date. Time can be a great asset and heal many ills, but that requires the lender’s cooperation. If all parties agree and believe in the potential of the asset, this can often be an easy solution.
Reduce the outstanding principal balance to an amount equal to or greater than what the lender would receive through foreclosure and quick sale. If the lender believes in the current ownership, this may be a cheaper and less messy alternative.
Modify the Equity Structure
You might not want a partner in your business, but bringing in an additional guarantor with superior financial strength could boost the lender’s confidence that the loan will be repaid at maturity.
Alternatively, if the means exist, reducing the principal balance with a cash infusion from a new partner can rebalance the deal and allow the property’s cash flow to service the debt going forward.Another strategy is to offer the lender participation or a future equity kicker in exchange for modifying the loan.
Gracefully Exit the Deal
Conduct a short sale in which a buyer purchases the property at a price less than the principal balance. Again, this may not seem realistic on the surface, but if it’s a market deal, the lender avoids foreclosure costs, and the borrower potentially avoids future negative implications caused by foreclosure.
Another method is to cooperate with the lender to forgive your personal guarantee by handing the property over via Deed in Lieu of Foreclosure, as opposed to fighting foreclosure through bankruptcy. This minimizes the potential of the lender seeking your other assets for repayment.
Shawn Hill is a principal at The BSC Group. He is responsible for advising clients regarding debt and equity financing and providing loan-workout services for all commercial property types, with an emphasis on self-storage. He can be reached at 773.517.8504; e-mail [email protected].