While the pandemic wreaked havoc on other real estate sectors, self-storage once again demonstrated its attractive resilience. As a result, capital sources ranging from large institutional investors to individuals have elevated interest in purchasing existing facilities or pursuing new construction.
Historically, self-storage development has been fueled when property sale prices rise above replacement cost, demand outweighs supply, or there’s an abundance of attractive interest rates and terms for construction loans. Right now, all of these factors are in play; so, if you’re considering a new development and need financing, following are some options and what you’ll need to meet lender expectations in today’s market.
Most self-storage construction loans are obtained through conventional banks or the Small Business Administration (SBA), but there are other options. When evaluating and comparing term sheets and applications, consider factors such as loan rate and amount but also how development fees are paid out, how the construction oversight and draw process works, and ongoing loan covenants and reporting requirements.
Conventional loan. You can expect 65% to 75% loan-to-cost (LTC) and no more than 60% to 70% loan-to-stabilized-value. Most construction loans are floating-rate and based on a spread over the prime rate or LIBOR. They usually have a three-year initial term with interest-only payments, and one or two 12-month extension options. The larger the project, the longer you want your interest-only period to be, not only to lease up the property but to burn off concessions. It’s conceivable that a self-storage facility with 100,000 or more rentable square feet could take four years to fully stabilize.
Keep in mind that construction loans require a completion guarantee and a personal guarantee for the repayment of principal and interest. Some lenders will allow the recourse to “burn down” once certain occupancy or operating-performance hurdles are cleared.
SBA loan. This can be a good option for self-storage owners who have less experience or want higher leverage. You can seek an SBA 7(a) or 504 loan. Each has advantages and disadvantages, so it’s helpful to work with a lender that has industry expertise.
SBA financing offers the ability to borrow up to 90% LTC. A 7(a) can usually be up to $5 million, and some lenders can provide an additional conventional loan to increase the total amount. Typical structure for a 7(a) would be interest-only for three years (one year to build and two to lease up), followed by an amortizing loan up to 26 years.
A 7(a) loan is fully funded by the lender and 75% guaranteed by the SBA, while a 504 loan is funded 50% by the lender with a fixed rate for 25 to 30 years and 35% funded by a Certified Development Company, a nonprofit that administers the financing on behalf of SBA. The second loan is fixed for 20 years. Either program requires personal guarantees.
Non-recourse financing. There are a limited number of capital sources—typically non-bank or private funds—that provide non-recourse construction financing for ground-up self-storage projects and conversions. These lenders often look to fund loans in excess of $10 million and will charge higher interest rates and points.
There are also select lenders that’ll reduce or eliminate recourse for lower leverage financing in which LTC is about 50% or less. You should anticipate that in all cases completion guarantees will be required through Certificate of Occupancy (C of O).
Bridge loan. Since construction loans often require personal guarantees and are based on LTC, some self-storage owners seek a bridge loan to pay off the construction loan, eliminate recourse, and possibly recoup some or all of the equity that was initially required. Bridge loans are typically for properties in some stage of lease-up subsequent to C of O. Terms are usually two to three years, interest-only and non-recourse with a variable rate often tied to spread over LIBOR. The spread and terms are generally more favorable as the facility reaches stabilization.
Refinancing. After a property reaches stabilization, the construction or bridge loan can be refinanced into a permanent loan, often with a longer-term, lower, fixed rate. If the economics allow, there may be an opportunity to obtain a return of equity based on property value and historical operating cashflow.
Most self-storage developers/owners seek construction financing near the end of the permitting process when they’re about three to six months from breaking ground. Under current conditions, expect that your project will be heavily underwritten and scrutinized. This isn’t necessarily because lenders are unwilling to lend for self-storage. In fact, it’s a preferred property type by many. It’s really more a result of increasing construction budgets and supply-and-demand dynamics in crowded markets. In addition, as the industry continues to gain sophistication, lenders are increasingly only willing to lend to experienced, proven operators.
Among other things, they want to fully understand the financial aspects of the development, often requiring a detailed breakout of costs and pro forma operating income. You’ll need to submit a construction budget that covers land, soft costs, site work (and offsite work, if required) and hard costs, along with a project timeline. Given the rising cost of materials, expect lenders to dig in and explore how to mitigate risks caused by cost overruns or construction delays. You may want to consider adding a larger than usual contingency line item for materials.
You’ll also need to provide a monthly projected operating budget through lease up, which should include a proposed unit mix, unit pricing, and a pro forma outlining revenue and expenses. The budget should show an interest reserve sufficient to service the loan during construction and cover any operating shortfalls until property cash flow reaches breakeven.
When creating a lease-up pro forma, many owners work with a self-storage feasibility consultant or third-party management company. These professionals often have access to a vast amount of local and national information to help you model accurately.
A final note: When underwriting, many lenders will discount the projected rent from current market rates to account for concessions during pro forma lease-up. Annual rate increases will also likely be eliminated.
Your chances of securing attractive self-storage construction financing hinges largely on your ability to communicate project viability to the lender. This includes your sponsorship’s financial expertise and strength to support and operate the facility during construction and lease up.
Securing a loan for a new development is only part of the journey. Choosing the right lender and loan can mean the difference between a smooth ride and one filled with bumps and potholes.
Neal Gussis is a principal at mortgage-banking firm CCM Commercial Mortgage. With 28 years of experience as a national self-storage mortgage broker and advisor, he specializes in securing debt and equity for self-storage owners nationwide. He can be reached at 224.938.9419 or [email protected].