Pumping The Brakes

Lenders Cautious On Financing New Storage Development

During the past two years, self-storage has enjoyed the attention of investors and developers as the industry has experienced rising occupancies and property valuations. New money has entered the sector for acquisitions, development, expansions, refinancing, and conversions.

Self-storage financing during the first half of 2017 can be characterized by relative stability in rates, terms, and access to funds. “Lenders are actively competing for deals. Interest rates remain very favorable, and, overall, the investment and financing climate is good,” reports Shawn Hill, principal of the Chicago-based The BSC Group.

“Long-term interest rates have remained relatively low with small periods of slighter higher rates,” says Neal Gussis, principal, CCM Commercial Mortgage in Skokie, Ill. “The longer term Treasury yields have been resilient and have remained low in the face of Fed target rates increases, inflation concerns, low unemployment, and national and global uncertainties.”

All this could be cause for celebration, but, of course, anyone can turn off the music and end the party prematurely. Perhaps the party pooper could turn out to be lenders, who have become increasingly cautious about the amount of self-storage development underway.

“You’re starting to see lenders pump the brakes,” Hill says. “It feels like we’re starting to get into the later innings of the development cycle. You have an uphill battle now and lenders have their guard up. As a result, you have to answer a lot of questions and provide lenders with a lot of information. They want to make sure the deal is going to lease up if they’re putting a construction loan on it.”

Development deals are still getting done, but owners should expect lenders to show up with magnifying glasses and a certain amount of skepticism.

“You have to prove out deals even more than you did before,” Hill says. “You have to show lenders and demonstrate even more than ever that there is demand for new product in that submarket; that the project is well conceived; that it will lease up; and sponsorship is viable and has the wherewithal and experience to stand behind the project.”

Lenders want information about the occupancies of other properties in the market, what’s been built locally, and how fast those facilities are leasing up. They also focus on new construction in the market and the prospect of competing storage projects coming in the future. They place a firm emphasis on sponsorship and look at the sponsors’ track record and financial strength.

A feasibility study is essential, preferably from an independent third party, especially for newcomers.

“For qualified borrowers and good locations, there are still many options,” Gussis says. He adds that first timers will face more challenges, which can be addressed with good sponsorships and a location that has supportable market dynamics.

Construction Buckets Filling Up

As an indication that development may be approaching the frothy stage, Gussis confirms that his firm has done more construction financing this year than in previous times. But that level may have already plateaued.

“In many markets, it is becoming tougher,” Gussis says. “Some lenders may have filled the quota of construction loans, while others may scale down the loan to cost. Construction buckets are filling up. To get in the door, you generally need to have experienced operators with financial statements having the best shot.”

The extent of new storage development has made some lenders wary of financing new projects, even though developers can demonstrate a recent history of rising occupancies and rental rates.

“Lenders are becoming more conservative on proforma in terms of how many months it’s going to take to lease up,” Gussis says. “Some lenders aren’t buying into increasing rental rates, so the proforma has to be based on market rates today versus market rates with bumps along the way.”

Terry Campbell, general manager of Live Oak Bank in Wilmington, N.C., has seen conventional lenders and local banks start to tighten up on self-storage lending.

“They are reaching their limit of commercial loans they want in their portfolio, and they don’t have the appetite for it now,” Campbell says. “Self-storage is a tricky animal to a lot of banks. They’re scared of how long it takes to lease up. Some banks might loan money to build it, but they’re not lending money to make sure they get to break-even once they are open and that’s the most critical part.”

He adds that some banks require from 25 percent to 45 percent equity in the transaction and some will not include sufficient working capital to get the project through break-even.

“For development deals, a multi-location operator can go to a regional bank that he has a track record of success with, or more likely with a relationship lender that he’s had a history with. That’s where the majority of development deals get done,” Hill says. “They tend to be lenders in the market they are operating in. A lot of times the bank wants to be in the footprint where the properties are because they are familiar with those markets and the fundamentals in that area.”

Multiple Lending Sources Available

Outside of the development arena, a variety of financing sources at attractive rates and terms remain available for self-storage owners. Securing financing depends on the financial strength of borrowers, their needs, and their level of storage experience.

“Larger owners generally have more capital sources looking to do business with them,” Gussis notes. “Because lenders seek to create relationships with larger operators, which include offering other services such as wealth and treasury management, they quite often are creative in providing compelling rates and terms to secure larger owners’ financing business.”

The good news for self-storage operators of all sizes is that financing funds generally are widely available. “Across the board, everybody has low interest rates now,” Gussis says. “Whether you’re large or small, there are still attractive financing rates available.”

Life insurance companies, local and regional banks, credit unions, private equity funds, commercial mortgage backed securities (CMBS), and Small Business Administration (SBA) loans are among the sources open to self-storage.

CMBS loans are designed for those seeking non-recourse, fully leverage loans where borrowers can cash-out and redeploy capital. CMBS lenders offer attractive rates and terms, however, loan minimums can be as high as $5 million or more. With facility prices and valuations escalating, more development is now in the $5 million to $15 million range, perhaps making the CMBS minimums more manageable for some owners.

“With change of regulations coming into play and bond market fluctuations, CMBS loan pricing has been more volatile than other traditional lenders, but today CMBS lenders are offering attractive terms relative to other financing alternatives,” Gussis says.

Life insurance companies also offer inviting rates and terms at conservative leverage levels, but their minimum loans are often in the $5 million to $10 million range. Credit unions are options to borrowers offering competitive recourse terms for stabilized properties.

“Operators all have different investment and financing risk profiles and, as such, usually do business with lenders that best suit their financing objectives,” Gussis says.

There is still plenty of capital waiting on the sidelines looking for opportunities to enter the self-storage space. Much of this new money takes the form of joint venture capital with existing operators or with private equity capital.

“A lot of money is finding its way to investment advisors who are able to place capital with firms they have deep relationships with in the self-storage space,” Hill says. “If a pension fund comes to an investment advisor looking for self-storage exposure, they may have a vehicle or relationship in place where they can help put that money to work. A lot of equity capital that’s been trying to find its way into the space hasn’t yet found an angle, but there are certainly some firms that have been successful.”

He cites Crow Holdings as an example of a viable source of capital that was not in the space a few years ago, but is now developing projects with various sponsors around the country.

Gussis says CCM takes calls regularly from newer operators who are getting into the business. One client who had no storage interests two years ago now operates 20 facilities.

“Self-storage is known as a performing asset class with strong drivers with consistent returns in the future,” Gussis says. “That’s why you’re seeing so many people in retail and office move into the sector.”

SBA In Play

SBA has been an active lender for numerous storage owners in recent years. These loans usually are placed through banks that hold special SBA certifications.

Live Oak Bank is a preferred SBA lender and has been active in self-storage since 2015. The bank has placed more that $250 million in self-storage loans in that time and processed 1,210 SBA loans last year. Live Oak is the second largest SBA lender in the country, according to Campbell.

“Our clients are typically small business owners,” Campbell says. “These folks want to get into the business or are in business and want to expand but don’t have huge amounts of equity you need for a conventional loan. We’re dealing with a lot of folks that are first timers, a lot of folks that are buying second facilities as an acquisition, or building another project.”

Many small business owners have been turned down by a conventional lender for a variety of reasons. “They don’t understand self-storage, or they’re afraid of construction, or they don’t like the ramp-up time that it takes to get from the day you open until you’re full,” Campbell says.

Projects and owners go through a vetting process before an SBA loan is granted. Live Oak requires a feasibility study by an independent third party the bank trusts to show that the project has a likelihood of success.

“We use those numbers to build in interest-only periods and working capital and have them come to the table with equity in some cases as low as 10 percent,” Campbell says. “Instead of taking all their money as a down payment, we’re taking what we have to and leaving the rest in their pocket in case they need it.”

Refinancing And Acquisition Funding

Refinancing remains active in self-storage as many borrowers face balloon payments at the end of terms ranging from three to 10 years.

“We’ve been very active with refinancing deals that are maturing or borrowers who are looking to strategically reset their debt,” Hill says. “They may want to lower their rate; they may want to take cash out; they may want to alter the structure or fix their rate on a non-recourse deal. Strategic borrowers want to take advantage of opportunities, and their debt is a great place to start.”

Gussis notes that since the last time borrowers refinanced, net operating income and valuations have increased while cap rates have compressed. “A lot of equity has been achieved that’s causing most refinancing in self-storage today,” Gussis says, adding that most owners are looking to redeploy the cash proceeds for new property purchases or expansions of existing facilities.

The financing market for acquisitions remains good, however, the appetite for acquisitions doesn’t appear to be as strong as in previous years.

“It feels like the acquisition market for the stable bread-and-butter stuff had slowed down and there is not as much of it going on. Things are priced to perfection,” Hill says. “Larger operators with institutional equity behind them, who are very well capitalized with a relatively low cost of funds, are still winning deals.”

SBA money is being used to make acquisitions of $3 million or less primarily in secondary and tertiary markets. “You have a lot more opportunities in secondary and tertiary markets to find deals that haven’t been marketed, haven’t been managed. You can go in and turn it around and make it a profitable facility,” Campbell says.

The majority of Live Oak’s SBA loans are used for acquisition and new construction. “We almost never do refinancing if someone has a lot of equity and their balloon is due,” Campbell says. “There’s plenty of local lenders that would love to have an existing business with great cash flow and good loan to value and they’re willing to do it at a low interest rate.”

The Effects Of Rising Interest Rates

Financing opportunities appear strong for storage owners going forward, however, it’s nearly impossible to predict how future national and global events will affect the markets.

The Federal Reserve Bank, which started to raise the short-term rate in late 2015 and continued the pace in mid-2017 to a target rate at 1.25 percent, has indicated more increases could be on the horizon. Steadily rising rates inevitably will affect the financial markets.

So far this year, however, Fed rates don’t appear to be making a major impact on financing. “Rates have come down since the beginning of the year,” Gussis reports. “Most of our longer term deals are being quoted at four to 4.5 percent, where at the beginning of the year they were closer to 4.75 to five percent.”

Hill notes that after the Fed increased its rate in June, CMBS rates, which are typically priced over 10-year swaps, actually dropped because the market had already priced in the rate increase.

Short-term rates inevitably will be affected by Fed rate hikes, however, long-term rates may react unpredictably. “For a long time now the banks have had a very low cost of funds and they have been taking market share from other sources of capital, but the increases are certainly having an impact on their cost of funds directly,” Hill says.

“I wouldn’t be surprised to see at some point the target rate up to three percent from 1.25 percent today,” Gussis says. “I wouldn’t be surprised if we saw an inverted yield curve where long-term rates were the same or lower than short-term rates.”

Rising rates are a reality that financial professionals along with self-storage owners are going to have to contend with. Live Oak Bank is already looking long term as it evaluates the merits of borrowers and their properties.

“When we look at projects, we shock them,” Campbell says. “What would this project look like if interest rates were three percent higher? If it works, then we still do the deal. We assume there could be a rate increase. As long as they do it a little at a time, it’s not quite of as bad of a shock. Eventually it will be an issue.”

With month-to-month rental payments prevalent in self-storage, owners may be able to raise their rents to cover increases in loan expenses. A 500-unit facility may only need to increase rents by $2 a month to cover rising interest rates.

No matter what the Fed, the President, or Congress do in the months ahead, rates are still very attractive and financing is readily available for most self-storage businesses today.

“The general consensus is rates are going up over the years,” Hill says. “Borrowers should focus less about where rates are headed and concentrate their efforts on making sure they have good financing in place and they’ve taken advantage of the opportunity to set their debt. It’s the bird in the hand theory.”

David Lucas is a freelance writer in Phoenix, Arizona. He is a frequent contributor to all of MiniCo’s publications.