A self-storage owner who is overleveraged in todays finance market may be concerned about the fate of his property. The good news is there are options available that will allow him to retain both ownership and control of his asset. Read on for self-storage debt-restructuring solutions.
Most commercial real estate investors are well aware of the financial turmoil that has occurred over the past several years. However, it may still come as a surprise to learn that despite the signs and sentiment of an apparent recovery, there are currently more than $60 billion securitized loans in some stage of actual default. Moreover, if one assumes theres a similar amount of defaulted portfolio loans being held by banks, insurance companies and other financial institutions, the sum quickly escalates to nearly $120 billion of defaulted loans in the commercial real estate market.
Although that number may be astounding, many industry experts estimate the amount is even greater. In fact, from the time the recession began to the present, the amount of CMBS (commercial mortgage-backed securities) loans in default went from less than 1 percent of total loans outstanding in 2007 to more than 9 percent in August 2011, according to Trepp LLC, an independent provider of loan and commercial real estate information.
Perhaps of greater concern, the number of CMBS loans scheduled to mature between now and 2017 is estimated at more than $400 billion. When adding the life-company, bank and government-sponsored enterprise products maturing, that number doubles.
Leverage: The Root of Current Evils
The driving force behind the current problem relates to leverage, and perhaps the most serious issue facing commercial real estate investors today is the potential equity gap between the value of their property and the amount of their outstanding debt. According to Moodys/REAL Commercial Property Price Index, in this recession, commercial real estate values have dropped by as much as 40 percent across the board from their peak in 2007.
Since it was not uncommon for commercial real estate assets to be purchased with an 80/20 debt-to-equity ratio, one does not need to be a mathematical genius to figure out that in light of post-recession valuations, assets may be worth much less than the outstanding debt amount. In fact, based on current estimates, its conceivable that up to two-thirds of all loans currently scheduled for maturity will not qualify for refinancing at an amount required to pay off the existing debt.
Illustrating the Problem: Practical Examples
A portfolio of storage assets generating $1 million in net operating income (NOI) five years ago, valued at a 7.5 percent cap rate, would have been valued at roughly $13.3 million. This portfolio would have likely qualified for debt of around $10.6 million in loan proceeds at 80 percent loan to value (LTV). If we assume the loan was interest-only with a five-year call, a very realistic note in the glory days of commercial real estate finance, and that the maximum available leverage in todays market lies at 70 percent LTV, a proceeds shortfall at refinance of roughly $1.3 million emerges.
If we take this analysis a step further and assume theres been some stress on the asset during the recession, resulting from either a deterioration of cash flow or an increase in cap rate, the magnitude of the shortfall can escalate rapidly. In this stressed example, lets assume a pretty realistic increase in cap rates of only 50 basis points. This minor increase, combined with the new available 70 percent leverage, inflates the proceeds shortfall to almost $2 million that will be needed to refinance the portfolio.
Although generic, these types of scenarios are very realistic because they illustrate the situation that many property owners, self-storage or otherwise, currently face. This can present a significant problem, as many owners dont have the equity at their disposal that will be required to recapitalize the transaction. Candidly, an owner faced with this predicament is undoubtedly in a tough spot. However, depending on the specific situation, there are likely options available.
The magnitude of equity erosion often dictates the options available to the borrower. If the equity erosion is contained and theres cash flow available to service the debt, the simple subordinate debt options can present a pretty straightforward solution for filling a short-term equity gap. In cases where equity erosion is more severe, however, a complete restructure of the debt may be a more viable solution.
Subordinate debt is a general term that refers to any additional financing lower in priority to the first mortgage and is a mechanism that can provide additional dollars and higher leverage to help bridge an equity gap like the scenario above. In the current market, subordinate-debt lenders will take a capital position between the first mortgage cut off and reach up to 85 percent or more LTV.
By reaching higher in the capital stack, subordinate lenders are inherently assuming more risk, and they get paid a higher rate of interest for doing so.
Interest rates on subordinate debt can range anywhere from 8 percent to 18 percent, depending on the transaction. Subordinate-debt lenders are often flexible and willing to structure the payments to match the cash-flow projections of the specific transaction. For example, the payments might be structured as an interest-only payment with a balloon, or amortized over time via routine interest and principal payments to reduce the debt.
The two most common types of subordinate debt are mezzanine financing and junior mortgages, or B-Notes. Albeit similar in application, there exist critical differentiating factors that will dictate which is proper for the specific transaction at hand.
Mezzanine-debt lenders provide subordinate debt thats secured against an ownership position in the borrowing entity, rather than the mortgaged property itself, as the collateral for the loan. Its essentially a pledge of the ownership interests in the property, rather than a pledge of property itself. As such, mezzanine debt is particularly useful in situations where the mortgage lender will not allow for secondary debt against the property collateral itself.
Alternatively, a junior mortgage is a secondary debt position thats secured by the mortgaged property as collateral for the loan. This mortgage is junior in priority to the first mortgage, or senior note (A-Note), hence the nomenclature. The two mortgage notes will likely differ in their terms, however the payment priority is clear, with the A-Note having clear priority over the B-Note. Since both notes are secured by the same mortgaged property as collateral, however, the subordinate nature of the debt is established through an agreement between the A- and B-Notes holders, referred to as the lender intercreditor agreement.
Equity Joint Ventures
In cases where equity erosion is severe and theres no longer adequate cash flow to service the existing debt, a complete restructure of the debt and equity may be a more viable option for the borrower. This effectively forces the sponsor to give up equity ownership and, in some cases, even the controlling interest in the ownership structure to entice new equity in to the transaction.
By definition, a joint venture is a business agreement whereby two or more parties agree to invest in a new entity and asset through the contribution of equity for a finite period of time. Together this new entity will exercise control over the enterprise and consequently share in the revenue, expenses and assets of the venture, the extent to which is determined during its negotiated formation. Joint-venture equity is typically available to commercial property owners in transactions where theres a significant upside in the transaction, often stemming from a development or recapitalization scenario and resulting in enhanced cash flow and, consequently, value.
Joint ventures are heavily negotiated and can be structured in a multitude of ways, depending on the specifics of the transaction. For example, in its most simplistic form, two parties could agree to contribute an equal amount of equity and subsequently split cash flow and profit equally going forward, until such time as the venture concludes.
Recapitalization transactions tend to be messy, therefore the terms of the venture are more heavily dependent on considerations such as the balance of sponsors equity remaining in the deal in proportion to the equity needed to recapitalize, as well as the perceived risk and reward associated with the transaction. There are key concepts that must be addressed when structuring a joint venture related to control, distribution of cash flow and exit.
Its imperative to understand who will control the venture, including the votes needed to make critical decisions, as well as matters of day-to-day operational control. In addition, its important to understand how the cash flow from the venture will be distributed, with consideration given to profitable items such as salaries and management to the extent that one party or another is more involved in these aspects. Finally, both parties must premeditate and understand the likely exit options as they relate to each partys investment time horizon and motivating factors.
While refinancing in todays market can be a scary venture for those who are overleveraged, there are options available. With a little brainpower and ingenuity, self-storage owners can retain both ownership and control of their asset. Going forward, as new amortizing loans pay down the principal balance of the loan, its less likely these problems will occur again in the future.
Shawn R. Hill is a principal at Chicago-based The BSC Group, where he provides mortgage brokerage, financial consulting, and loan-workout solutions to self-storage real estate owners nationwide. To reach him, call 312.207.8237; e-mail [email protected] ; visit www.thebscgroup.com .