Navigating the closing process in todays self-storage market hasnt exactly been smooth because of recent capital markets fluctuations. But the closing process can certainly be more streamlined if a buyer takes the proper precautions and performs the necessary due diligence related to the transaction.
While the letter of intent and contract in a self-storage sale are still primary steps in the closing process, underwriting has become much more stringent than it was three years ago, or even one year ago. Lenders who agreed to finance self-storage facilities in the second and third quarters of 2007 are having a difficult time fulfilling their commitments.
The ability of lendersparticular conduit lendersto finance storage properties has greatly decreased. Following the sub-prime mortgage crisis, the conduit-loan market all but dried up, and alternative sources are taking over. In addition, a number of investors are borrowing from local banks, regional banks or life-insurance companies. In most cases, banks or life-insurance companies can expedite a loan closing faster than the troubled Wall Street conduits.
Local and regional banks are taking advantage of this opportunity to gain market share, and some are offering loans without prepayment penalties. A variety of solutions are being implemented with these lenders to facilitate transactions, including seller carryback, bridge debt, short-term variable debt and assumable financing.
Overall in the commercial real estate market, some risk premium has returned, with cap rates expected to rise by an average of 20 to 50 basis points by the end of 2007. Higher-quality assets in strong markets, and those with assumable or seller financing, will be affected the least. Market-wide, while increased borrowing costs and limited price appreciation will put upward pressure on cap rates, a dramatic correction is not expected.
Looking at current investment trends, self-storage buyers and lenders have become more discerning, causing a greater distinction in cap rate and pricing trends based on quality and location. Lenders have become more selective, showing a strong preference toward historically tight markets and top-quality properties that can show current strong occupancy and rent growth. Local market factors play a much more critical role once again, as opposed to the broad-based cap rate compression from 2001 to 2006.
On average, commercial real estate prices have increased 60 percent to 90 percent over the past five years, resulting in a significant build-up of equity. The current disruption to capital flows and higher financing costs will be overshadowed by investors opportunities for attractive cash returns and building long-term value.
Furthermore, the tremendous amount of equity in the market is helping to offset lenders lower loan-to-value requirements. For many investors, mitigating risk has become a primary objective. As baby boomers near retirement, demand for lower-risk investments with stable returns will rise substantially. For investors with a higher risk tolerance, opportunities still exist for self-storages with above-average upside potential. Deals that rely heavily on future rent and occupancy growth, however, will require borrowers to put more cash down to satisfy current requirements with still higher rates.
What to Expect
Normally, the closing process for self-storage properties takes 60 to 120 days from start to finish, a constant even in the wake of the lending shifts. After a seller places a property under contract, a buyer has 30 to 45 days to conduct due diligence and then another 30 to 35 days to close on the loan. Additionally, the elements of the closing process have remained the same.
An earnest down payment and contract are needed up front. The contract includes provisions for title insurance, surveys and physical due diligence. Physical due diligence includes inspection of all aspects of the property: roofs, gutters, drywall, foundation, driveway, etc. Buyers should allow enough time to conduct the due diligence, acquire a loan, and close on it because there are a number of pitfalls that could occur along the way. Land surveys can reveal easements or encroachments, for example, that sellers may not know about, slowing the process tremendously.
Recent shifts in the capital markets have cut into commercial real estate transaction velocity, but healthy fundamentals in most prime markets will help to sustain investors interest. Furthermore, with a healthy supply/demand balance and expectations for continued rent growth, liquidity is forecast to return to the market well ahead of the residential sector. While velocity has slowed, the decline is due almost entirely to changes in the lending environment, as buyers remain in the market.
As financial institutions have tightened their lending requirements and conduits have essentially left the market, most private investors must front a larger down payment. As a result, many of the inexperienced investors who initially entered the self-storage market to make a quick profit by taking advantage of record-low down payments and interest rates have been weeded out. More sophisticated buyers are stepping off the sidelines and reclaiming their seats at the closing table.
Charles (Chico) LeClaire is vice president/investments in the Denver office of Marcus & Millichap Real Estate Investment Services. He is also a senior director in Marcus & Millichaps National Self-Storage Group. He can be reached at 303.320.1300; e-mail firstname.lastname@example.org.