Yea or Nay? Refinancing a Self-Storage Loan in Today’s Volatile Finance Market

The debt markets look a lot different today than just a few years ago when historically low interest rates were prevalent. Rates have risen sharply since March 2022 when the Federal Reserve began an aggressive campaign to curb record inflation through monetary policy. This increased the Federal Funds Rate, the overnight borrowing percentage between lending institutions that heavily influences U.S. interest rates. The higher the overnight rate, the more expensive it is for consumers to borrow money.

High market rates require more thoughtful consideration by borrowers. If you’re a self-storage owner looking to refinance an existing loan, you must think through your timing, investment horizon, loan structure and other variables. Let’s examine reasons you might move forward, pros and cons, and what to expect during the process.

Reasons to Refinance

An obvious reason to refinance in the current market is loan maturity. In this instance, a self-storage owner has no choice, unless they decide to sell their property or pay off the loan. Another reason would be to pull out equity or effectuate a cash-out.

You may also want to improve terms not directly related to interest rate. For example, you may want a longer amortization, prefer interest-only payments, or wish to try for a non-recourse loan. Though often overlooked, the suite of structural levers that can be pulled to manipulate one’s loan constant are among the most practical enhancements a borrower can deploy to improve their cash flow after debt service in a tricky and volatile market.

Another case to be made for refinancing under current market conditions is if you have a loan structured with a prepayment penalty that’s effectively “in the money.” For example, some borrowers with legacy, commercial mortgage-backed securities (CMBS) debt are in position to receive a settlement statement credit if they refinance because their defeasance (one of several prepayment-penalty methods) is actually at a premium.

Finally, some borrowers will choose to refinance simply because they believe more volatility and higher rates are on the horizon. The list goes on, but all of these situations can warrant action.

Pros and Cons

If you want or need to refinance your self-storage loan, it’s important to weigh the pros and cons. First, let’s look at the advantages:

Cash out. Pulling cash out of a deal, even at a higher rate, can be beneficial. Unlike sale proceeds, these earnings aren’t subject to immediate taxation. It can also give you the funds you need to complete facility projects or pursue other investments.

Better loan structure. Refinancing may improve your loan terms. For example, if you currently have a 20-year, amortizing, recourse loan but can move to a 30-year amortization, it might merit doing so, especially if your payment will decrease.

Fixed rate. Depending on your outlook, locking in a fixed rate might make sense. If you believe we aren’t through the volatility storm we’ve been experiencing and another rate increase could be on the horizon, pursuing this avenue may be in your best interest.

In thinking about potential cons to refinancing self-storage in today’s market, an obvious one is the risk of a higher loan payment. While keeping all other variables constant, a higher rate means a bigger payment. Here are some other drawbacks:

Closing costs. Many lenders charge some form of origination fee, which can range from .25% to 2% of the loan amount, depending on the product. In addition, common items such as third-party reports, surveys, legal and underwriting fees, and more will add to your transaction costs, often around 1%.

Broker fee. If you hire an intermediary like a mortgage broker to assist in the transaction, that’ll be another cost. Some lenders actually defer their origination fee to this person since they like to have them in the transaction to help ensure an organized and smooth closing.

Prepayment penalty. If the incumbent loan has one, that cost must be factored into the equation.

Need for more equity. Often, there are ways to offset the negative impact of the above factors, but that isn’t true when refinancing results in a cash-in situation. This occurs when the deal underwrites to proceeds below the current debt, which requires an infusion of equity. This isn’t usually common in self-storage; however, in certain high-leverage scenarios, coupled with elevated interest rates, it’s a problem more borrowers may face going forward.

The Refinance Process

Once you’ve weighed the pros and cons and decided to refinance your self-storage loan,  it helps to understand the process. The first step is to decide how much to borrow. Consider the outstanding loan balance as well as the closing costs and other fees. You must also decide whether to consider a cash-out or less-desirable cash-in.

Next, compile all the necessary documents into a debt package. This includes financials, facility-occupancy reports, tax returns, a personal financial statement, balance sheet and other diligence items. Once this information is gathered, you’re generally ready to “shop” the debt.

If a mortgage broker is involved, they’ll market the deal to a pool of lenders to obtain loan quotes. If you shop the package on you own, you’ll approach a smaller set of lenders, mostly comprised of local banks with whom you have relationships. In either case, lenders will provide soft quotes or term sheets outlining their proposed loan options.

Once you’ve chosen a lender, a more rigorous underwriting and closing process begins. This’ll include ordering third-party reports along with title, survey and zoning documentation. Underwriters will also compile questions for you to answer. At some point, attorneys will be engaged to work through the documents.

As the transaction nears its end, outstanding deliverables are exchanged; loan documents are reviewed and finalized; and eventually, funds are disbursed by the title company. Borrowers can expect the closing to occur 30 to 90 days after signing a term sheet.

Lender Perspective

Now that you grasp the self-storage refinance process, it’s helpful to understand the guidelines and requirements to which lenders adhere when reviewing opportunities. Just be aware that property- and sponsor-level underwriting requirements vary by lender and market.

For example, when underwriting a permanent loan, a debt-service coverage ratio (DSCR) of at least 1.25 is common. This means the facility’s the net operating income needs to be 1.25 times the amount of the annual loan payments. This was higher a few years ago, but changing dynamics have softened it in some instances. In fact, some lenders have underwritten a lower DSCR coupled with interest-only payments if they believe a pro forma supports higher coverage in the future. They also commonly apply minimum expense ratios to hedge cash-flow underwriting.

On the sponsor side, lenders have minimum net worth and liquidity thresholds that are evaluated with a borrower’s personal financial statement and debt schedule. It’s critical to be forthright about past credit issues and the circumstances surrounding them. Most hiccups can be digested if disclosed early, but even seemingly minor issues can become problematic if withheld.

On a final note, it’s increasingly common for lenders to focus on relationship-driven executions. This can include requiring that accounts and deposits be held at the bank just to get you in the door.

Weigh Your Options Carefully

As you can see, a lot goes into a self-storage refinance decision. It’s best to be armed with as many salient facts as possible but also to understand what you can and can’t control. The last few years have yielded new challenges as well as opportunities, so it can be helpful to lean on the advice of a mortgage broker who understands the industry or even a mentor who’s been through the process.

In a challenging market, the contrast between good and bad loan executions is magnified. Self-storage owners must weigh their options and objectives carefully to position themselves for the most positive experience possible.

Adam Karnes is a vice president of The BSC Group, a Chicago-based boutique mortgage banking firm. As a broker, he specializes in financing commercial property types nationwide, with an emphasis on self-storage assets. He’s underwritten more than $4 billion in loan requests since joining the firm in 2015. To reach him, call 262.527.0528; email [email protected].