In the past four years, it seems loans for construction financing have been on the edge of extinction. Such loans became unpopular due to the recession and the sudden over abundance of self-storage properties in certain markets, many of which have had lower than projected rents and disappointing lease-up velocity.
Between 2007 and 2011, it was not uncommon to see lease-up plateauing between 40 percent and 60 percent for some newly constructed properties. Coupled with leverage that, in some cases, exceeded 80 percent, plus the high cost of land, many lenders ended up being responsible for distressed loans and real estate-owned properties that sold well below the original loan amount. This made lenders leery of giving construction loans. Today, this once-flourishing loan type can certainly be considered an endangered species.
Fortunately, in the past year, there has been a glimmer of hope for those seeking to secure construction loans for self-storage. There are lenders familiar with the storage industry who know that just because one market is overbuilt or has had bad luck doesn't mean another market isn't in need of new supply. By knowing where and how to apply for a loan, as well as some of the particular considerations for self-storage construction lending, you can take these loans off the endangered-species list.
There are several terms you must first understand when it comes to construction financing. They include the following:
Term: One of the major lessons learned by borrowers over the last downturn in the cycle was to make sure you have a sufficient cushion in your loan term to allow for slower than anticipated leaseup. Prior to the market crash in 2008, many construction loans had a term of 36 months. However, due to a slowing economy, many facilities were not stabilized at the end of the loan term, leaving the borrower and the bank in a precarious position. To avoid this, I suggest negotiating a four- to five-year term with a few one-year extensions.
Rate: Interest rates are at historically low levels. For variable-rate loans, we're currently seeing spreads between 275 and 450 basis points over the 30-day London Interbank Offered Rate (LIBOR) and -50 to 150 basis points over Prime, a rate of 3 percent to 5.5 percent. On a fixed-rate loan, active construction lenders are offering three- to five- year fixed rates between 4 percent and 7 percent. The low interest-rate environment makes this a very attractive time to develop, as it reduces the overall cost of construction.
Loan to cost (LTC): The LTC constraint is fluctuating between 50 percent to 80 percent, depending on the transaction specifics. The LTC is dependent on the bank, the strength of the borrower and the quality of the property. A strong borrower with a short track record in self-storage and a reasonable project may be required to contribute as much as 50 percent of the project cost in cash, whereas a strong borrower with a long track record and an excellent project, who bought the land or conversion property at the "right price" or below market, may be able to achieve 80 percent LTC. Higher LTC loans are also more easily achieved when the delta between the construction capitalization (cap) rate and the residual cap rate is larger.
Interest-only and interest reserve: Most construction loans today are still interest-only or have a period of interest-only. Interest-only refers to what's included in the payments made to the bank during the term. Because there's no cash flow during the construction period and cash flow is very tight during leaseup, banks will allow the borrower to pay only the interest due and not require any paydown of the principle loan amount.
Additionally, banks will create an interest reserve, which essentially allows the borrower to borrow the funds needed to make the monthly interest payments, which is extremely helpful during the construction process. If no interest reserve is set up when the loan is negotiated, interest payments need to be made out of the borrower's pocket. It's important to negotiate a large enough interest reserve to take you through leaseup and give you a bit of a cushion in case of construction delays or slower than anticipated leaseup.
Local and regional banks are still one of the only sources for construction financing. Given the struggles many lending institutions have had over the last four years, it can be hit or miss as to whether a specific bank will entertain construction financing. The reason the majority of construction loans are done by regional and local banks is these institutions are best equipped to understand the dynamics of the local real estate market and are comfortable with many of the localized risks associated with construction projects.
A select number of national banks will finance construction loans nationwide, however, they typically work with more experienced developers. Many loans are "relationship" loans, which means a large part of the credit decision to lend is based on the strength of the borrower and his past banking transactions with the lending institution. So, if you have an existing relationship with a current bank, it may be the best place to approach regarding a construction loan. After that, I recommend other local banks in the area. The easiest way to access national and regional banks is through a mortgage banker.
The most important part of securing a construction loan is demonstrating a firm understanding of the market to the bank. A bank will want to see a feasibility study addressing the following:
Depth of the market. Based on the demographics of the surrounding area and the growth trends, how much square footage can the market absorb? Is this a first-rate location? Location matters to lenders. You need to prove your location is a sure thing. Currently, infill locations in top-tier markets are the easiest locations to finance.
Absorption. What is the anticipated lease-up rate? How have other construction projects leased up in the competing area, and where did they stabilize? The old idea that you can project 2 percent per month and stabilize the property at 86 percent is no longer true. When seeking a loan, you must go to great lengths to prove the absorption rate.
Pricing. What's the most likely rent you'll receive based on the market? How does the rent relate to the construction costs and demographics? If land and construction costs are too high, you'll need to charge higher rents to justify them. However, are these higher rents supported by the economy in your designated trade area?
Competition. Who are the competitors in your area? What do their properties look like? What are their occupancy levels? The presence of competitors can indicate a need for self-storage properties, but it can also indicate market saturation that can make your business less profitable and turn off lenders.
Construction costs. The lender will want to see an analysis comparing your construction costs to industry averages and other units in the area. In several markets, existing properties are selling below replacement cost; therefore, it may make more sense to acquire as opposed to develop. Your feasibility study will help you determine which option is right for you.
Zoning. It's important to know the zoning regulations in the area in which you wish to build. Is the parcel properly zoned for self-storage? Zoning restrictions of future development are a major barrier to entry. Being able to quantify barriers will go a long way in getting your loan approved.
Return on investment. Based on the construction costs, anticipated rents, lease-up rates and other factors, what type of return can the investors expect?
All banks require this "feasibility" study, though how the study is performed will vary from institution to institution. Some banks may ask for a third-party feasibility study, while others will accept one generated by the borrower. Many times the bank will accept a borrower-generated feasibility study and rely on the appraisal to verify the claims. Regardless of whether you hire a third party to perform the study or do it yourself, as the borrower, you need to know the feasibility of the project before you seek a loan.
The financial strength of the borrower is as important as the feasibility of the project. Construction loans require a full guarantee from the owners of the borrowing entity. In the industry, this is commonly known as a full-recourse loan. As construction loans come back from extinction, it seems only the strongest borrowers are getting financing. Lenders consider a borrower's net worth, liquidity and global cash flow to determine if the borrower has the financial strength to pay down the loan.
Another important consideration for banks is the borrower's experience in developing successful self-storage locations. In my experience, it seems only the most seasoned developers have been able to access construction financing. However, based on the bank, the borrower's relationship with the bank, financial strength and the merits of the development, a bank may be willing to work with less experienced developers. Your relationship with your local bank can work in your favor here, as can a strong and compelling feasibility study.
Another consideration is the pro forma, the actual number crunching. Credit officers at banks are numbers guys, so an important part of any potential transaction is the financial projections that support the project. A pro forma should detail anticipated revenue and expenses on a monthly basis from the completion of construction through leaseup.
It's imperative you demonstrate a strong understanding of the economics behind the asset class (multi-family differs from industrial, which differs from self-storage, etc.). You need to demonstrate the project will be profitable, there will be sufficient income to pay the mortgage, and leaseup is fast enough to replace the construction loan with a permanent loan prior to the end of the construction-loan term.
Improvement in the permanent market is one factor that's bringing construction lending back from the edge of extinction. When the capital markets were at a standstill, construction lenders were hesitant to make loans because they didn't know what the exit strategy would be. The improved permanent market has alleviated this concern. The lender is going to want to see that the project is profitable enough to support a permanent loan greater than the amount of the construction loan.
When creating your pro forma, it's important to be realistic with your projections. If you're too aggressive with the leaseup rate or your expenses are too low because you're trying to be optimistic, you'll give the appearance that you don't understand the industry. It's also important to include different financial scenarios, including an expected case, an upside case and a downside case. Make sure that even in the downside scenario there's a strategy to pay off the construction loan. All of your projections must be supported by the feasibility study.
Lastly, consider your management group. Now more than ever banks are concerned about the management of the proposed facility. Management groups have received heightened scrutiny due to the number of transactions that have stalled prior to projected stabilization over the last few years. This has largely been due to a lack of experience or a misunderstanding of project scale.
In the bank's eyes, an outside management firm is preferable unless the borrower has a significant track record in self-storage management. Hiring a third-party management firm gives the bank confidence that the people running the day-to-day operations have sufficient experience, thus mitigating a major risk.
Despite the difficulties, the endangered construction loan is ready to flourish. There has been virtually no development over the last three years in the self-storage industry, so many investors are looking to development as a way to grow their portfolio. Because of the lack of development, we've seen a better balance of supply and demand in many submarkets.
Additionally, inputs are cheap, as vendors are trying to put their people to work and move product. Combined with the low interest-rate environment, the aggressive cap rates for stabilized facilities, and the upward pressure on rates in certain markets, self-storage construction loans stand to make a comeback from being an endangered species to being a thriving opportunity for self-storage developers.
This article has been reprinted with permission from Inside Self-Storage, the premier magazine of self-storage professionals. For information, visit www.insideselfstorage.com.
The BSC Group has been voted Best of Business - Finance for five years running by the readers of Inside Self-Storage.