Self-Storage Construction Financing in Today’s Economically Difficult Environment

Interest rates play a pivotal role in shaping various sectors of the economy, including self-storage real estate. When they rise, they can have a dampening effect on activity. Higher borrowing costs reduce profitability and may slow purchasing and building decisions, potentially leading to a cooling market.

Construction financing plays a vital role in the self-storage development, but its availability and terms can be influenced by broader market conditions and investor appetite. During periods of economic downturn or volatility, lenders may tighten their underwriting standards and become more risk-averse. Owners and builders must be prepared for the cyclical nature of this market and adapt their finance strategies accordingly.

For certain, it's become more difficult for borrowers to obtain funds, especially as banks become more selective. They typically want to lend to well-established developers with proven track records and substantial collateral. They may require deposits, recourse and more credit structure to deploy. Some regulatory pressures and summer stress tests are causing some banks to pause lending altogether.

The good news is, though the lending market is tougher, there’s still liquidity for the right self-storage construction project. Let’s explore strategies to help you secure financing.

Have a Plan

If you’re looking to develop a self-storage project today, a solid business plan is critical. Lenders want to see a long track record of successful projects in various real estate cycles. Underwriting assumptions are much more disciplined in this environment, with a sharp focus on the lease-up schedule and rent-growth assumptions.

Capital is starting to underwrite a much longer lease-up period and more conservative rent growth moving forward due to current macro-economic trends. We’ve seen many lenders who, in an effort to mitigate risk, will not underwrite any type of rent growth through the first 12 to 24 months the self-storage facility is operating.

In evaluating potential construction borrowers, lenders are paying particular, close attention to the existing supply in each market. They’re reviewing it within a three- to five-mile radius and will exercise caution in markets that have high self-storage per capita. One of the best ways to ensure lease-up takes longer than usual is to open in an area with many new projects; so, if you’re able to find pockets where no facilities are being built, you’ll be best positioned to capitalize.

Population growth is another important metric lenders take into consideration. If your target market has strong population in a three- to five-mile radius, it can help get the deal done. If there isn’t a strong population story for the subject site, there will need to be projected growth for the area in the years ahead. For this reason, lenders also look at the amount of new residential or multi-family development that’s recently been completed in the market.

Finding Liquidity

Credit enhancements such as recourse notes are largely dominating the construction-financing market today. There is non-recourse capital out there, but it’s selective and may price considerably higher, which decreases project profitability.

Many lenders are open to a burndown schedule of the assigned recourse on the loan as the project progresses through the development cycle and starts to lease up. Typically, this burndown is triggered once the property receives Certificate of Occupancy and can rent self-storage units. As the facility begins to hit specific cash-flow levels or debt-service coverage ratios, the amount of recourse will decrease as negotiated.

If you’re willing to bring a large number of deposits to the bank, this helps to enhance the liquidity available for construction. Recently, banks have been requiring borrowers to deposit anywhere from 5% to 15% of the loan. Higher requirements are a new in this market and an effective way for banks to increase their deposit ratios.

Guarantor net worth and liquidity are also important components in the availability of construction financing. The amounts required will vary based on the capital provider. Pricing will also differ greatly based on the lender, project and borrower background. So, there’s liquidity in the market, but it comes at a price.

Operational Headwinds

There are also operational headwinds causing some concern with self-storage cash flow. For example, there’s been significant upward pressure on property taxes and insurance, which have weighed heavily on expense ratios and profitability. Construction lenders want to see that you’ve conducted proper due diligence at the county or municipal level for these expenses.

Due to the challenges in obtaining construction financing, the supply curve has started to decline across multiple property sectors, including self-storage. This barrier to entry has sidelined many projects, which has given developers conviction in trying to get them capitalized today in the hopes of delivering in a favorable window tomorrow.

The inherent risks, high capital requirements, stringent lender criteria and market conditions pose significant obstacles. However, engaging a knowledgeable commercial real estate advisor can help developers increase their chances of obtaining capital. There’s money available, but to get it, you’ll need to get your book together on the actual deal and be prepared to answer the qualitative aspects of your business plan.

John Williamson is the director of debt and equity placement for the self-storage team of JLL Capital Markets, a global provider of capital solutions for real estate investors and occupiers. He has more than nine years of experience in real estate transactions, with a focus on self-storage debt advisory. He has extensive experience in debt and equity placement, acquisitions and dispositions, real estate valuations, and consulting services, and has been involved in more than $4 billion in commercial real estate transactions. To reach him, call 832.455.5740 or email [email protected].