A Walk Down Wall StreetThe state of financing in the self-storage industry

January 1, 1999

14 Min Read
A Walk Down Wall StreetThe state of financing in the self-storage industry

A Walk Down Wall Street

The state of financing in the self-storage industry

By Tara Collins

Though reserved,lenders and Wall Streeters are optimistic for 1999. While the market took a hard turnduring the last two quarters, things are beginning to look up for self-storage ownersseeking debt and equity. Most sources agree that interest rates will remain at currentlevels; however, potential borrowers can better their chances by improving their ownstandards, and if the money doesn't flow from traditional sources, a look at financingalternatives can often fill a fiduciary need.

Capital Markets Impact

"As you know, the market has slowed down, particularly in the last quarter, due tothe volatility of Wall Street," observes Neal Gussis, senior vice president at FirstSecurity Commercial Mortgage in Chicago. "The downturn was attributed to bond marketinvestors and their flight to quality or safety. Shying away from corporate bonds andcommercial mortgage-backed securities (CMBS), people were investing in safer things suchas U.S. Treasuries. The upward swing in 1999 can be attributed to a higher confidencelevel. Investors have come back. We're back in a time period when the economy is verygood. Yet, there are economic factors that could still cause volatility. But the financingcompanies backing the market have taken measures not to be caught off guard as they werelast year," Gussis explains.

The outlook is good. But pricing has increased. Spreads over Treasuries have gone up.There are less players willing to loan money. But the consensus is there's still a lot ofcapital out there.

Michael Sneden, executive vice president/head of origination at New York-basedValuExpress says he looks forward to a productive year. "Essentially, the capitalmarkets recovered faster than anyone ever imagined. Lending in the self-storage area, aswell as the other asset classes, has come back quickly and almost to the level ofaggressiveness as mid-year last year. I think 1999 will be a good year for permanent loanson self-storage facilities," Sneden says.

A bit more skeptical is Ray Wilson, president of CRW Associates, an appraisal firm inPasadena, Calif. "My general perception is that the markets are still doing verywell," he says. "Last summer, the CMBS market came to a screeching halt becausebond buyers moved out. Now that's turning around. Bond buyers are coming back into themarket again, albeit at higher rates than offered in the last 14 months. However,borrowers are a bit apprehensive, holding back, waiting until the rates come back down.The question is, will the rates come down? The lenders say they probably will not. Theborrowers are thinking, 'Well, if the lenders have a lot of money and product is availableto loan on, eventually the rates will come down.' But it's really anybody's guess."

Some argue that borrowers have gotten spoiled by the low-interest-rate availability."Interest rates aren't really all that high," continues Wilson. "They arereasonable compared to most real-estate loans today, particularly compared with what wasavailable in self-storage up to about 18 months ago, before the rates got too low."

As for Wall Street, it's just a matter of time before money becomes available forself-storage owners. Bradford Stoesser, analyst at Morgan Stanley Dean Witter (MSDW) inNew York, thinks borrowers will have to wait and see how the market reacts in the nextquarter. "Currently, we are not doing self-storage deals. That's mostly due to themarket's current status. Obviously business is good and the value of companies is comingback in line with stock prices. But, we'll have to see how things play out in the next twomonths," Stoesser says. "Because self-storage tends to be development intensive,it is usually one of the later sectors to receive financing."

Lending Options

Many lenders and bankers are eager to generate new business in 1999. Some are tailoringprograms to meet the needs of large and small operators. "I think more people willrealize that self-storage is a good property type to be lending on," says CheriGrossman, senior vice president and manager, small loan program, at Heller Financial--NewYork. "We provide fixed-rated financing for stabilized properties, permanent 10-yearloans with 75 percent loan-to-value. Our loans, generally for refinancing andacquisitions, start at $500,000 with no upper limit."

On the other hand, ValuExpress is a conduit lender. Self-storage is approximately 5percent to 10 percent of their overall lending business. "We lent out about $5million last year to self-storage owners," notes Sneden. "Generally, we doone-property deals. We channel our self-storage business through two small loan programssupporting deals in the $250,000 to $2 million range, typical of the self-storageuniverse.

"Our first program has lower upfront fees to cover reports such as engineering,appraisal and environmental. Initial fees for this small-loan program including lender'slegal costs, about $5,000. Borrowers pay a slightly higher interest rate, about a quarterpoint higher than the other program, where we get more detailed pre-closing reports. Totalupfront fees here cost about $7,500 to $10,000. The interest rate is lower, currentlyrunning at about 8.5 percent," outlines Sneden.

ValuExpress has tried to meet the demands of the market and offers a few constructionloans in conjunction with banks, usually following up with permanent loans upon lease-up.But, 98 percent of the lender's business is straight permanent loans through Wall Street."We will go up to 80 percent of the purchase price," adds Sneden. "We prideourselves on speed and service. Many people who want to buy or revamp their propertieswouldn't go to a conduit because they think they can't get a loan fast enough to meettheir contract requirements. Up to $2 million, we have streamlined our applicationprocess, making it easier to get the acquisition loans closed within 60 days."

At First Security, 1998 outpaced the same volume of loans it did in the two previousyears, which was about 60 deals annually. "We primarily offer permanent financingloans for acquisitions. Most borrowers are choosing between two different types ofloans," explains Gussis. "The 10-year term with a 25-year amortization providesborrowers good cash flow on a monthly basis. After 10 years, a bullet or balloon is due.So, the operator goes back to the well to refinance or pay off the note. The otherborrowing philosophy is the 15-year fully amortizing loan. This approach pays off the loanover 15 years and provides the borrower with a good investment vehicle. It's more like a401K investment, whereby after 15 years, you have an asset that is fully paid for. Whichloan a borrower adopts depends on the borrower's investment strategy. People who leantowards selling the property tend to go for the 10 to 25."

Alternatives to Financing

Whether an operator is looking to exit the market or expand his portfolio, he canexercise a few options. "At First Security, we do offer alternatives to financing ona deal by deal basis," adds Gussis. "For example, we have access to nonconduitfunds or non-Wall Street funds for shorter term loan with more flexible pre-paymentprovisions."

Financing alternatives also include 1031 tax-deferred exchanges, property swaps foroperating partnership units, equity fundraising and public/private placements. The 1031 isa stepping stone into and out of the self-storage industry. Kevin Gannon, managingdirector at Robert A. Stanger & Co., an investment banking firm in Shrewsbury, N.J.,looks at this scenario to make a point. "Assume, for example, you are elderly and youwant to exit the business. The property's too much work for you. But you don't want totake the capital gain for the property. You find a buyer who wants to swap. It's aone-for-one trade: your $5-million self-storage facility for his $5 million, triple-netlease property (or any other property type).

"This transfer provides you with two advantages. First, you get out of theoperating demands. Second, the new property type allows you to get a more assured incomestream. Instead of going to manage a property everyday, you clip coupons from an AA/Acredit on a tax-deferred basis. Here you collect a 9 percent to 10 percent yield on yourproperty value for 10 to 20 years. The downside is that you're in an illiquid property.You can find a buyer later, but this approach may not be as lucrative as putting yourmoney in stocks. The alternative is to sell the storage property outright for cash, takethe taxable gain, pay the taxes, be left with roughly 70 cents on the dollar, and reinvestthat money in the stock market."

A second option to selling out is exchanging the property for operating partnership(OP) units. "Today, there are fewer willing buyers on the OP units side," saysGannon, "because OP units were crushed in terms of value in the past six to eightmonths. However, there are a few out there who still have pretty healthy appetites. The OPunit downside is they are originally illiquid assets. You convert them later into stocks,usually one to two years down the road. However, once you turn the stocks in for cash, itbecomes a taxable event for you, and you pay taxes. The other advantage to this approachis that you may be able to borrow against it. For example, if you have $5 million in OPunits, you may be able to borrow $2 million to $3 million cash tax-free against a loansecured by your units."

A third alternative to financing is equity fundraising. Here an investment banker workson an operator's behalf to solicit funds from public, private or pension investors. InJuly 1998, Stanger assisted Devon Capital Management in raising $100 million. Devon had$100 million worth of assets under management and wanted to expand its portfolio withoutincurring the burden of loans and interest.

"You have to have some size to do this type of deal," warns Gannon. "Itwould be hard to do a $20 or $30 million equity fundraising; it takes just as much timeand energy to raise $100 million." While the terms of the Devon deal are proprietary,Stanger basically organized a business plan with specific objectives and solicitedpotential investors for the deal. A match was made with a private investor, allowing Devonto conduct expansion under its own terms. Hence, Devon is able to buy appropriatelyfitting properties without the time constraints of securing a loan and the overtones ofloan payments and interest. "The disadvantage to equity fundraising is that youspread your risk a bit," notes Gannon. "But the advantage is that you accesscapital now to grow more quickly. Taking advantage of promising marketplaceopportunities more than offsets the cost of having a new partner, i.e., sharing the upsidewith somebody."

Lastly, as Wall Street comes around, investors should be ready to handle the demand."On MSDW's investment management side, we invest directly in the stock of the companyitself," notes Stoesser, "holding those stocks in our portfolio in either ageneral account or a client-specific account. Our core group invests in real-estatesecurities in a fund, so the companies we deal with are public. MSDW doesn't leverage adeal like in a loan. We exchange cash for stock and then sell the stocks when appropriate.Our Special Situations group deals with private sector while our banking side raises thecapital for IPO deals."

Be Prepared, Be Qualified

Lenders and investors alike are concerned with a facility's operating history,stabilized occupancy and location. At ValuExpress, mortgages are almost entirely based onthe cash flow of the property. Says Sneden, "We look at the property's last threeyears' operating statements. We're concerned with the income produced by the assets. Thepersonal credit of the sponsor is secondary. These are nonrecourse mortgages; the sponsoror individual does not personally guarantee the loan. Instead, we secure the properties ascollateral."

First Security's Gussis agrees. "We offer nonrecourse loans with standardexceptions, which means we look to the strength of the property. We look at the stablesupporting, historical net operating income (NOI). The debt service coverage is generally1.30 or better today. That means a borrower should have at least 30 percent more NOI thanthe debt service or loan payments on an annual basis."

MSDW looks for high occupancy rates. "We look for potential inside value like lowrents with upside." says Stoesser. "Facilities should possess good location,both geographically nationally and within the city itself. One consideration is urbanareas. They tend to have higher rents and occupancy. They turn over quicker, tenants stayless time, and the rents are actually higher. In rural areas, there is a tendency forrates to decrease as the tenant stays longer."

Heller Financial looks to the operator's experience. "We like to see someone whohas been in the business, the longer the better," Grossman points out. "Aborrower's knowledge of the market impresses a lender. How well has he studied the market,its demographics, square footage per capita, income levels, etc.? Don't simply quote thatthe other self-storage facilities in the market are doing well. Look at what the bottomline can generate. Research your market and let your lender know you know what you'regetting yourself into."

Lenders and investors are beginning to look at self-storage now as a stand-aloneproperty. Years ago, it would be compared to retail or hotel analysis, or simply lumpedinto industrial. "Lenders are scrutinizing the product at a more sophisticated levelthan before," observes Michael Kidd, executive director of the Self StorageAssociation (SSA). "Wall Street is looking at this property type closer and with moreintense analysis. Yet, a good transaction continues to entice the lender. They know whatquestions to ask about a market. Their first question will be, 'Is a market saturated, ordoes it have room to support a new facility?' Recessionary resistance is this product'skey asset; self-storage is resilient in good and bad markets."

Kidd sees residential construction as an indicator to increased self-storage productand usage. More and more house movers and home purchasers are calculating self-storagecosts into their move. The local self-storage facility is becoming an integral part ofhome buying. "I think you will see strong attention being given to conversions,renovations and modernizations vs. building a new facility from scratch," Kidd says."Interest rates ultimately affect delivery of a product. Addressing the concerns ofoverbuilding will require more work and calculations of would-be borrowers when it comesto defining their project to a lender. Lenders want to see owners presenting awell-thought-out professional business plan."

Perceived Excess

"There is a perceived notion that self-storage has become overbuilt,"continues Kidd. "Unfortunately, that concept was arrived at without the benefit ofcumulative statistics. Data is not readily available as other individual property typesbecause it is often lumped together with other industrial portfolio statistics, such asretail. While some markets are overbuilt, not all markets are totally saturated. It wouldbe unfair to assume that all markets are closed. While it's hard to get a nationwideoccupancy figure, self-storage facilities are running at 85 percent to 90 percentoccupancy nationwide," says Kidd. "Other property types envy that level."

Heller's Grossman is not as optimistic. "My impression of the industry right nowis that there is a lot of inexperienced people who see bottom-line cash flow and find thisvery intriguing. The costs to build aren't that large, and people think it is easy to getinto this business. They see a profit to be made. But in essence, they don't have anyexperience to run this type of business. So, I'm a bit concerned about overbuilding, ofunder-experienced operators getting into the business. This may hurt the industry and thetop-notch operators. But then again it may provide opportunity for them as well. Oncethese people build, they may find it's not that easy to run a facility. These newly builtfacilities will eventually be brought to market as one-timers get out of theindustry."

Searching the Horizon

Profitable sales prices reflect not only good properties on the auction block, butindicate buyers are paying premium dollars for professional management and propertyadministration. The biggest news of 1998 was Public Storage acquiring Storage Trust."What this impact will be on the industry is anyone's guess," notes SSA's Kidd."I'd watch the pace of REIT acquisitions. Their movement often indicates a strongfinancing trend. I think additional consolidation will continue in the future, be it fromlarge publics or smaller privates expanding their asset base. There was a slight declinein REIT acquisitions in 1998. But, there is no definite proof thatsales-cost-per-square-foot was down. Hopefully, self-storage sales will follow the trendin the real-estate market, which should be up. But, don't let a decline fool you; it'sstill a seller's market in self-storage."

As for the buying market, activity is evident. "There are quite a few transfersgoing on," notes Wilson. His company appraised almost $2 billion in self-storage overthe past 24 months. "Most properties are not being transferred at a loss," heexplains. "But, the REITs have almost totally backed out of the market at this point.Many don't have any money right now to speak of. Last summer, because their stockunderperformed, they backed out of the acquisition market all together. Acquisition pricesjust got too high. REITs were paying a premium over replacement costs."

While REITs continue to merge with each other, smaller owner/operators dabble in theacquisition market as well. "What I see are the funkier asset classes, likeself-storage and hotels, benefiting from this situation," observes ValuExpress'Sneden. "The capital markets are providing tremendous opportunities for borrowers tolock in low interest rates, take cash out, and do whatever they want with it. By takingequity out of their projects, owners can continue doing other projects or make otherinvestments. It's a great time for people to borrow in the self-storage area. Treasuryrates are low and it's unclear how long they will stay there. So they should jump on thebandwagon while the opportunity is hot."

Robert A. Stanger & Co. (RASCO) is an investment banking firm specializing infairness opinions, equity fundraising and property-portfolio sales. In the last fouryears, RASCO has assisted self-storage clients with assets totaling more than $2 billion.For more information, call (732) 389-3600.

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