Creative Deal Structures for Today’s Self-Storage Facility Sales: Seller Financing and Equity Partnership

Getting any real estate deal done can be difficult, but when you account for the interest-rate environment that’s impacted self-storage and other commercial real estate in the last year, it can be near impossible. Despite rates still being historically low compared to those of the late 20th century, they’re double what they were just a short time ago. As a result, there’s often a disconnect that prevents buyers and sellers from coming to terms.

Prior to the rapid interest-rate hikes of 2022, sellers were enjoying record-high valuations thanks to low capitalization (cap) rates in the midst of a low interest-rate environment. This was coupled with spiking operational performance during the COVID-19 pandemic.

Unfortunately, the mindset shift is much slower than the recent interest-rate bumps. Banks are requiring higher debt-service-coverage ratios at astronomically higher rates, resulting in much lower purchase price or leverage capabilities. Sellers who haven’t experienced changes to the operational or physical attributes of their facilities are being told their assets are worth significantly less than 12 months ago.

To bridge the divide between what a seller can stomach and what a buyer can provide under these harsher lending conditions, creative deal structuring is a must.

Seller Financing

There’s no one-size-fits-all approach, but there are situations in which creative self-storage deals are warranted. An obvious one is when a seller wants more than what a buyer can offer.

Think about it: The current interest rate is more than 100 basis points higher than the average sales cap rate from last year. Self-storage owners who are finally getting around to selling are often asking for prices that would cause the loan to be underwater if a typical loan-to-value of 75% were used. However, if it were possible to remove the bank influence from the equation, it’s possible the buyer would be able to offer more money, and the seller would get closer to their ideal price.

For example, consider seller financing. If the seller is willing and able to “be the bank,” offering a lower interest rate than the bank, the buyer could offer a higher purchase price. This creates additional upside for the seller through interest income as well as the ability to spread capital-gains taxes over multiple years.

If a seller values security above all else, then removing the bank, financing the majority of the purchase themself and receiving a decent-sized down payment is likely the best route. Just bear in mind that banks now love lending on self-storage, so if a seller wants to finance the deal, they’ll need to offer terms better than a bank would provide. If not, there’s little reason for the buyer to agree.

Equity Partnership

If a self-storage seller isn’t willing to fully play the role of being the bank, another solution is to go in partially on the deal. Many lenders allow a second-position mortgage depending on a couple of conditions. For example, Small Business Administration (SBA) loans allow for seller participation of varying structures and amounts depending on the type of loan the buyer is seeking. In addition, conventional lenders will often allow for a secondary mortgage as long as the total debt is less than 75% loan-to-cost (LTC).

An assumable mortgage can be at a lower interest rate than a new mortgage, and the difference in underlying principal balance and the desired purchase price can often be seller-financed in second position. The seller-provided mortgage may not have as big an impact on the purchase price as full seller financing, as there’s still a bank interest rate involved; but it’ll result in a lower, blended interest rate between the bank and smaller second loan. This provides the buyer with more comfort in offering a higher price for the property.

Under this structure, the bank wants the seller in second position for security, so it really comes down to seller priorities and capabilities. Maybe they want more money in their pocket or no longer wish to deal with day-to-day self-storage operation. Maybe they want better tax benefits than would otherwise be available if they sold the facility outright. In this case, participating in the deal to lower the interest rate and increase the sale price can be a great option.

Working with the seller as an equity partner can be a win for the buyer, too. When a seller contributes financing to a new self-storage ownership entity in exchange for a combination of mortgage pay-off, cash in hand or equity, the buyer gets a great loan at a lower LTC. It also reduces the amount of cash out of pocket or funds that need to be raised and boosts their returns. Plus, they’ve met the seller’s needs.

All in all, an equity partnership helps shorten the transaction timeline and really aligns the mutual goals of the buyer and seller. It can be particularly advantageous for expansion opportunities because the existing self-storage property being contributed will improve the collateralization consideration of the bank providing construction funds, assuming the site isn’t encumbered. 

Potential Drawbacks

Of course, there can be pitfalls to structuring a seller-carry self-storage transaction. For example, sellers sometimes make understandable but unreasonable requests for periodic balloon payments (lump-sum payoffs) over the course of the loan. These are desirable from the seller’s perspective since they optimally spread out the capital gains of the sale, but they make the deal nearly impossible to pencil out favorably for the buyer. The facility cash flow likely won’t cover these payments, and holding those funds in reserve in the event of syndicating the deal will make the return metrics very slim.

Similarly, sellers sometimes request a purchase price that’s only viable within the exact conditions of the seller-finance structure, offering abnormally advantageous terms to get to the closing table. But at some point, the buyer may wish to refinance or sell, and at that point, everything can fall to pieces. The buyer (now the new owner) needs to either offer the next owner similar terms—continuing a game of musical chairs—or be prepared for a much lower valuation than what they paid. There ends up being a large gap between the value of the property and what’s owed to the previous seller.

That said, if the deal has considerable value-add opportunity, such as room for expansion or starting rental rates that are dramatically below market, then the transaction may be able to cover the spread between the artificial facility valuation and the true market value as determined by the refinancing bank or new buyer. Realistic projections can help determine what’s feasible without getting too far out of range.

Get Creative

Increased interest rates, lower valuations, capital-gains taxes, tighter banking terms, and capital redeployment can make the self-storage real estate landscape difficult to navigate for both buyers and sellers. By approaching deal structures creatively, with a win-win mindset, seller financing and equity partnerships can be used to cross the transactional finish line with everyone coming out ahead.

Steven Wear is co-owner and chief marketing officer of Chicago-based Self Storage Syndicated Equities, which provides access to tax-advantaged self-storage investments, with an emphasis on wealth growth and social stewardship. Under his guidance, the company has acquired dozens of self-storage facilities nationwide at an average of 28% discount to market value. To reach him, call 847.666.8885 or email [email protected].