Financing a personal residence usually includes just two elements: the mortgage and your equity. Financing for commercial real estate, on the other hand, can be much more complex, involving several parties and a variety of structures. The full set of sources used to fund a project is called the “capital stack.” In fact, there are a number of instruments that can be a part of a self-storage transaction, some of which have become more popular in the last 15 to 20 years.
In the early stages of a project, the investor (or sponsor) will often seek a loan from a bank at the lowest possible interest rate, subject to underwriting requirements. They’ll also be required to contribute a certain amount of their own capital, to be counted as their equity in the investment. To meet the capital requirements and close the gap between the total forecasted project cost and the portion the bank will approve, the investor may wish to seek additional financing in the form of a secondary loan or additional equity from another source. This capital stack can be tailored to meet the requirements of the sponsor, project and additional investors.
Let’s focus on the four main components of the capital stack that you’ll most likely use when investing in a self-storage project. They are senior debt, mezzanine debt, preferred equity and common equity.
Senior debt is secured by a mortgage or deed of trust on the self-storage facility itself. If the borrower fails to pay, thereby defaulting on the loan, the lender is entitled to foreclose and take the property title.
This reduces risk on the principal invested because, at worst, the lender owns the facility and will look to maximize value by selling the property or the nonperforming loan. The “cost” of this lower level of risk is a lower yield on the money loaned. Senior debt lenders (banks) will be entitled to a lower return than all higher positions in the capital stack; however, they also enjoy payment priority in first position.
Senior-debt lenders underwrite the project and perform a thorough financial analysis to determine the sponsor’s (borrower’s) ability to service the loan. The debt-service coverage ratio and total leverage will play a major role, as will the experience and track record of the borrower.
Mezzanine debt is a secondary loan that bridges the gap between the senior lender and the equity. Mezzanine loans are usually priced two to three points higher than senior debt, and often carry heftier fees to originate and exit. They typically bring an additional 10% to 15% of capital to the stack, but rarely cover the remaining balance of capital needed to close.
In order of payment priority, mezzanine loans are positioned below the senior debt. In cases where the stack includes mezzanine debt and preferred equity, the former typically enjoys priority and, consequently, offers a lower rate.
Preferred equity and mezzanine debt fulfill similar functions in the capital stack: They’re forms of “bridge financing,” a method of fulfilling short-term capital needs to fill a gap between the debt and equity components of the overall project’s capitalization.
Preferred equity usually comes in the form of a fund or when several investors participate in a syndicated fashion through a Securities and Exchange Commission Regulation D instrument, such as a 506(b) or 506(c). Preferred-equity holders have a right to payments over common equity holders. That’s why they’re “preferred.” Because of this, as well as recourse they may have in the event of borrower default, preferred equity is considered less risky than common equity. Hence, the investor’s entitlement to upside may be capped.
Preferred-equity positions range from “hard” equity, which functions similarly to mezzanine debt and includes a fixed coupon and maturity date, to “soft” equity, which is more likely to include some of the financial upside if the project performs well. While hard holders may have the ability to make some decisions or remove the borrower if that person fails to make payments, soft holders typically have limited rights. As you’d imagine, the rate of return for hard preferred equity is similar (or slightly better) than mezzanine debt, while soft preferred-equity returns can be substantially better.
Common equity is the top of the capital stack. It’s the money the investor/borrower will be required by the lender or other equity investors to invest to have skin in the game.
Common-equity injections carry the greatest risk because the agreements entitle every other form of capital to be repaid first. However, if the property performs well, common-equity investors usually have no cap on their potential returns. In most projects, equity is typically structured so that all investors earn a preferred return until they hit a certain annual hurdle, say 8% or 10%. Beyond that, the sponsor/developer will earn a share of the profit (i.e., 40% of all remaining), while investors receive the balance of the pro-rated profit.
Though common equity generally has the highest risk and upside of the capital stack, not all investments are created equal with respect to risk/return profile. For example, many syndicators will offer a healthy preferred return to the equity partners in an effort to mitigate some of their downside risk and ensure their project gets funded.
Other attributes of an equity investment can impact the attendant risk and potential upside. Some of them include:
- Capitalization rate: How conservatively is the exit (or going out) cap rate projected?
- Market: Generally, higher-profile markets like Los Angeles or Miami will offer more downside protection (less risk) but also less upside potential. This is because dense, affluent cities enjoy robust, diverse rental demand but are some of the most competitive real estate markets in the world. It’s no wonder that places like San Francisco become particularly appealing for global investors in times of economic volatility. Conversely, lesser-known secondary and tertiary markets may offer more growth opportunities and upside for commercial real estate investment, but greater risk due to less-established, less-diverse local economies.
- Business plan: Equity investments can offer an array of risk/return profiles based on the underlying strategy. The amount of capital expenditure needed, the complexity of the project, and the in-place rent roll and cash flow all impact risk and potential return.
Understanding the various investment structures across the capital stack is critical when building your self-storage portfolio. The way in which you layer your equity and debt should depend on your overall goals and strategy, as well as your risk tolerance.
With the real estate market still facing a number of challenges as a result of COVID-19, diversification across investment structures and target-hold periods is all the more critical. The strain on credit markets may generate more opportunity for private lenders and, hence, senior and mezzanine debt opportunities,
After many years of a bull market, in which good-value equity investments became increasingly scarce, this massive disruption of the global economy will create a wide array of new opportunities across markets and the capital stack, as new debt and equity-capital needs emerge. For most investors, a diversified approach makes sense. For principals, the continued influx of new capital to self-storage across the stack has contributed to the sustained volume of acquisitions and new development thus far in 2021.
Scott Meyers, founder of Self Storage Profits Inc. and Kingdom Storage Holdings, has been involved in the self-storage industry as a developer, owner, syndicator and operator since 2005. He and his companies have bought, sold, developed and converted more than 2.2 million square feet of storage nationwide. His website, selfstorageinvesting.com, provides information, software and seminars to help people launch and grow a self-storage business. To reach him, email [email protected].