When deciding on the loan terms it can offer a self-storage borrower during a refinance, a lender’s primary focus is to analyze the property’s underwritten net cash flow relative to the request. That number is based on historical cash-flow statements.
Knowing how to prepare your operating statements for the lender is critical because of their impact on the loan terms, including but not limited to the interest rate or coupon, loan proceeds, and the amortization schedule. Collectively, these are the most effective ways a self-storage owner can maximize his after-debt-service cash flow and return on equity.
Before we dig too deep, you should know that underwritten net cash flow represents the bank’s conservative annual budget for your property, using its own internal criteria. While these criteria vary slightly from bank to bank, they’re consistent in principle, which is to reflect what the cash flow would look like if the bank foreclosed on the asset. While most banks have no desire to own and operate your self-storage facility, they do need to know what its cash flow would likely be if they were forced to foreclose.
Underwritten net cash flow represents the budget the bank creates, which generally doesn’t factor in any potential upside but does include some downside scenarios, such as real estate tax reassessment or rising electricity costs. That said, it’s important to remember several things before submitting your operating statements to a lender.
Using a third-party management firm may be the best choice for some self-storage owners, but it’s important to know the impact it can have when you’re ready to refinance. Many property-management companies create budgets that are conservative on revenue and expenses. Their realistic growth estimates are muted, while expenses are budgeted to increase by more than what’s actually assumed. This is so they continually “hit” or surpass numbers and keep their owners happy.
If your management firm is consistently beating its budgets, you may not want to send its budget for the next year to your lender. Unfortunately, a lender will ignore any expected increases to revenue (unless you’re in lease-up) while using any possible increases in expenses, which is where you may be negatively impacted. This ends up hurting your loan terms since the underwritten cash flow may include these increased costs.
If your management company won’t change its budget to reflect a more realistic base case, the best course is to provide your own budget. After all, it’s your property. If you decide to send the management company’s budget, closely review and compare it to the trailing 12 months income and expenses and can comfortably say you agree with the figures presented. This is time extremely well spent.
Repairs and Maintenance
Also, be wary of using an operating statement compiled by your accountant for tax purposes. An accountant may take capitalized items (like roof replacement) and enter them as expenses rather than delay full recognition of them, thus increasing your cost basis in your carried basis. This is so you can take deductions for this year’s taxable revenue rather than long-term capital-gains deductions by increasing your tax basis for when you sell the property.
While the lender wants to see all your repairs and maintenance expenses, it isn’t looking for replacements on your operating statement. It will likely ask for that information separately in a history of capital expenses; however, that schedule is to demonstrate your willingness to reinvest in your asset.
This is why it’s important to understand the difference between maintenance and replacement. For example, if you experienced an issue with your HVAC system and paid someone to repair it, that’s known as repairs and maintenance (R&M). If the system was replaced, that’s a capital expenditure (also known as capex) and shouldn’t be included in your operating statements.
The reason capex should be excluded is because the lender will underwrite them separately, regardless of what’s in your statements. While it’ll look at historical operating expenses to identify trends and underwrite the best estimate of expenses on a line-by-line basis, capex don’t occur in nice annual, even periods. Many items last five to 20 years, which means they fail or are replaced intermittently. This is why the lender will include an annual average capital expense below the line or net operating income. By leaving capital replacements in your historical R&M, you’re likely double counting your capex and eroding the debt terms your property deserves.
Non-recurring expenses should also be omitted from your operating statements for the lender. These represent costs that aren’t expected to return, for example, a one-time legal fee or an upfront payment for information technology.
Non-property-related expenses should also be removed—items like donations, car payments (even if you take your car from home to work) or life-insurance premiums, which your accountant includes in your tax return. In the unlikely event you default on your mortgage and the lender takes ownership of your self-storage property, loan officers won’t be putting their life-insurance premiums or car payments through the expenses. The lender is looking for recurring, property-related expenses, with capital expenses removed.
Other line items to exclude include things like interest, amortization and depreciation. Interest and amortization relate to your current mortgage, and most lenders will exclude those because they’ll put the proposed interest and amortization separately below the line. Every lender will want to pay off all forms of existing debt (and will confirm so through title searches), so these interest expenses should be removed.
Depreciation expense is another accounting strategy, a legally permissible way to reduce your state and federal taxes. While most self-storage facilities have a few things that can be continually extended with proactive maintenance and replacement of capital items, the federal government will allow owners to depreciate their property improvements by a 39-year life. Your accountant will deduct land (which doesn’t depreciate) and depreciate the remaining property improvement value by 1/39th each year. Depreciation isn’t a property expense and should be excluded from operating statements.
While you may be nervous to make some of these adjustments to your operating statements, particularly when asked to certify them, you should feel comfortable doing so. I encourage you to footnote any adjustments and tell your lender about them. Not only will the lender agree with what you did, it’ll likely thank you for taking the time to understand its business and helping it find you the best possible loan terms.
Gregory J. Porter is the founder of Summit Real Estate Advisors, a New York-based mortgage brokerage specializing in self-storage properties. Gregory is a former, 20-year lending veteran with commercial mortgage-backed securities lenders such as Deutsche Bank and JP Morgan, where he was a senior underwriter. He also served as the chief underwriter at Barclays PLC, with a $100 million signature authority. To reach him, call 917.701.5145; e-mail email@example.com.