It’s hard to believe that it’s the fourth quarter of the year already, a time when we reflect on 2016 and begin planning for the year to come. And what a year it has been for the self-storage industry as demonstrated by strong operational performances by most operators and the continued capital market realization that storage is a highly viable commercial real estate asset class.
While an industry as complex and diverse as ours will always present some challenges, it has been a banner year for storage financing as well, with great availability of capital and loan programs to sustain and support the industry’s long-term growth prospects.
And Property Economics
In almost all markets, occupancy levels are strong as we finish out 2016, with large and small operators able to increase their rental rates. While historically high occupancies with upward trending rents bode well for presenting a loan request, stay attuned to your market and the possibility of new competition if you are seeking financing. Lenders can be more cautious with loan terms and leverage if new competition is entering your immediate locale. Even worse, lenders will likely make downward adjustments to your income when deriving a loan amount if your revenues decline due to these new competitors.
The storage industry is also experiencing a paradigm shift in which mid-size and large owners, as well as the REITs, have better management tools and marketing exposure that support superior occupancy rates at market leading pricing. Their expertise and track records motivate lenders to create relationships with these operators, who in turn capitalize on financing programs offered by aggressive lenders that feature competitive interest rates, longer fixed rates periods, limited recourse, and other attractive structuring terms.
Even with our industry’s unique real estate nuances, local, regional, and national lenders (primarily banks and commercial mortgage backed securities (CMBS) lenders) have embraced self-storage as an attractive financing market. Today more banks than ever will lend on self-storage, while CMBS sources have remained steady during the year. However, the art of finding a lender that lends on self-storage properties comes down to the difference between one who understands self-storage and wants to lend by providing aggressive loan terms, versus the lender who will lend by offering conservative rates and terms relative to other property types.
Most CMBS lenders will consider financing storage, however some facilities do not qualify for many of their programs because they oftentimes have minimum loan terms of $5 million or more. Nevertheless, there are still many CMBS lenders to choose from with some aggressively seeking and focusing on self-storage. Additionally, life insurance companies, which offer attractive rates and terms at more conservative leverage levels, often have minimum loans sizes of $5 to $10 million. On the other end of the spectrum, banks have lending limits based on total asset size, so some banks may not be competitive as loan amounts increase because the loan request is too large. Be sure to understand your financing options based on the size of your loan request.
For the past several years, the Small Business Administration (SBA) has financed storage loans with many SBA lenders completing financing deals at local and national levels. While it took a while for banks who offer financing through the SBA 7a or 504 program to understand our property type, there is at least one SBA lender, Live Oak Bank, with a team dedicated to self-storage. SBA financing has opened the door to many new developers who could not previously obtain traditional construction financing as well as owners who use the benefits of increased leverage to expand their existing facilities or develop new ones.
Other active lenders include credit unions which, compared to banks, offer competitive recourse terms for stabilized properties. In terms of value-add transactions, most often resulting from an acquisition with a repositioning plan, there are numerous bridge lenders offering various recourse and non-recourse terms at risk-adjusted interest rates with 12- to 36-month term periods.
Valuation And Leverage
Cap rates for all self-storage properties classes continued to compress throughout 2016 by 0.50 to 0.75 percent, resulting in historical low rates. Cap rates are inversely related to value, so values increase as cap rates decrease.
Among the parameters lenders use when quoting loans is a minimum loan to value, thus the ability to boost your requested loan amount increases as values increase. However, lenders will also limit loan amounts to certain debt service coverage (DSC) ratios which are usually 1.25 to 1.00 or greater. In cases where a property is being purchased at an aggressive cap rate or based on its future upside potential, the ability to borrow maximum dollars could be governed by the lender’s minimum DSC.
Creative And Aggressive Loan Terms
Global economics and bond markets, combined with the Federal Reserve’s hesitancy to increase rates, created a sustained low interest environment during 2016. When indices such as the 10-year Treasury and treasury swaps are near historic lows as they have been for the past year, financing spreads move based on other market factors. So, even if indices continue downward, the mortgage rate paid by the borrower may not decrease proportionately.
Another interesting financing trend is that many banks today are breaking from conventional terms to build their own loan portfolios. Bank management continually looks to manage their loan portfolios, so they’ll find ways to offer creative lending terms if a self-storage deal fits nicely into their mix. This year, we’ve seen banks offering fixed rate terms up to 10 to 15 years, amortizing loans for 25 to 30 years, providing non-recourse or partial recourse based on lower leverage points, and being more lenient with prepayment terms. While banks will consider a refinancing cash-out on a case by case basis, CMBS lenders are generally more accepting of large cash-outs. Bank credit standards have also loosened slightly this year, but are staying in check thanks to regulatory and FDIC oversight.
Lastly, any lender’s policies and portfolio mix change over time based on performance results. A lender who may have been very aggressive on a deal may not necessarily offer the best terms for the next one. By creating relationships with lenders, monitoring the market, and researching alternative financing quotes, borrowers are more apt to receive competitive financing terms.
Cautious Credit Policies And Regulatory Pressures
Bank credit committees and compliance departments have remained in check due to conservative regulatory oversight and guidance stemming from the 2008 financial meltdown, with today’s credit underwriting being incredibly thorough and complete. In particular, there have been regulations and guidance on the level of construction loans relative to the bank size as well as requirements for borrowers to have real cash equity in a transaction as a percentage of stabilized value.
In late December, risk retention regulations will come into effect in which CMBS lenders and bond investors must retain a portion of a deal’s bonds. CMBS lenders are now testing several different acceptability structures for when these rules come into effect. It’s likely that costs associated with retaining a portion of the securities will cause interest rate spreads to rise as we enter 2017.
Staying Cautiously Optimistic
Availability and cost of capital directly affect construction, valuations, and property sales. It is hard to predict where banking and capital markets will be in the future given the unpredictability of national and global events that affect deeply intertwined financial markets. A decision halfway around the world, such as 2016’s Brexit vote, can certainly impact lending standards on Main Street USA.
A few simple tips you can follow as you look toward 2017:
- Keep an eye on the road ahead.
- Maximize the operating performance of your investments.
- Pay close attention to self-storage trends at a national, regional, and local levels.
- Watch economic and banking markets since they may have as large an impact on your property investment as your daily operations.
With more than 23 years of experience as a national self-storage mortgage broker and advisor, Neal Gussis is a principal at CCM Commercial Mortgage, where he secures debt and equity for commercial real estate properties with a focus on self-storage. He has been trusted by owners nationwide to secure more than $3 billion of self-storage transactions. Based in Chicago, he can be reached at 224-938-9419 or ngussis@CCMCommercialMortgage.com.