An Alternative to Traditional Construction Financing: CMBS Debt Execution

August, 2013

As construction financing has dried up over the past five years, so too has the construction of new self-storage inventory. With flat supply and increasing demand from a growing economy and population growth, in some markets there may be an opportunity for storage owners to expand their facility or grow their portfolio through new development. How to finance this expansion or new development, however, is evolving.

The Traditional Way

One option for self-storage owners is to pursue traditional construction mini-perm financing from a local bank. Although construction financing is making a resurgence, it is still relatively difficult to come by and typically requires strong sponsorship with full recourse guarantees, which may be prohibitive for the "average" borrower. If construction financing is achievable, it likely exposes the borrower to recourse against personal assets, including their home and savings. For some this risk may simply be too great.

The shorter-term nature of construction mini-perm debt exposes these borrowers to significant interest rate risk. Consider that the period between the commencement of construction and the take out of the loan with long-term permanent debt typically lasts 3-5 years, depending on the size and lease-up rate of the facility. In a rising interest rate environment there is tremendous exposure to upward movement in rates.

Finally, as we have recently witnessed during the economic downturn, banks can be extremely vulnerable during periods of economic uncertainty, which may lead to unpredictable and erratic behavior. For example, although it is by no means routine, it was not an uncommon story during the downturn about lenders that changed direction midway through development projects, forcing the sponsors to find alternative debt solutions or inject significant additional equity to complete their projects. Similarly, banks have failed or been taken over by other, healthier banks, whose lending strategies and objectives may be different and not as construction-friendly.

Construction financing surely has risks; however there is another way to finance your expansion or new development project.

The Alternative Way: Nonrecourse Proceeds

An alternative method involves using CMBS debt to refinance an existing facility and cash out equity; this equity can then be used to fund the expansion or new development. One of the many benefits of using CMBS debt is that these lenders generally allow for significant cash out at refinance, often times well above the existing loan balance. These excess proceeds have no strings attached, so the money can be used to expand a property or develop a new facility using all cash. To be clear, CMBS lenders are not collateralizing the expansion or new development, but only the existing, stabilized real estate, leaving the expansion parcel or new development free and clear of any mortgage liens.

Additionally, with 10 year, fixed-rate, non-recourse CMBS debt, self-storage owners can avoid any exposure to interest rates for the 10-year period, significantly reducing the potential volatility to post- debt service cash flow. It is very difficult to project where interest rates will be three years from now, however given we have recently witnessed some of the lowest rates in history, it seems likely they will be higher than they are today. At the time this article was written, 10-year CMBS debt was pricing in the low 5's percent.

A final benefit to CMBS debt is the elimination of bank failure or takeover risk because the borrower is no longer exposed to the health of their local lender. Whereas a traditional construction-financing package may change during periods of economic uncertainty, cash out at closing is cash in the borrower's pocket, which is the very definition of "money in the bank".

Why CMBS Debt?

Many lenders, including banks and credit unions, are skeptical of allowing borrowers to cash out at refinance, and life insurance companies are by nature more conservative lenders, many times limiting leverage to 60-65% LTV. Alternatively, CMBS lenders offer aggressive advance rates and terms. Because CMBS loans are ultimately securitized and sold in the market as bonds, CMBS lenders base their lending decision around the sustainable cash flow from the real estate, so long as there will be sufficient cash flow available to meet the debt service obligation and ensure bondholders are made whole.

Who Should Pursue This Method?

Using this method to fund expansion or develop a new facility is appropriate for owners with stabilized facilities that have paid down a portion of their existing debt via loan amortization, or otherwise added significant value to the property during the interim since the last loan was put in place. The bottom line is that there must be significant equity appreciation in order to cash out sufficient proceeds. A borrower who just recently stabilized his or her facility and is looking to refinance their local bank construction loan will likely not be a good fit, because there has been minimal pay down in debt and or asset appreciation.

If you are expanding your existing facility, it will be necessary to carve out the expansion land as a new parcel so that it is not encumbered by the CMBS loan. Once development is complete and the facility is fully stabilized, the expansion or new development can be financed and the equity can then be redeployed into the next project.

Real World Case Study

In 2004 a West Coast self-storage owner refinanced his 72,000 SF, fully stabilized facility via CMBS debt and was able to cash out roughly $1,250,000 in equity. The non-recourse CMBS debt was fixed for 10 years at approximately 5.50%, which was a great rate at the time. By combining the cash out proceeds and the equity that had accrued from excess cash flow, this sponsor was able to develop an additional 38,000 SF Phase II without the need to incur additional debt. The expansion land was parceled out and was not provided as collateral for the CMBS loan that now encumbered Phase I.

Phase II was developed throughout 2005 and came online in early 2006. By 2007 the expansion space had fully leased up and was ready for permanent, fixed-rate financing, allowing the borrower to recuperate some of his equity. The borrower used a national lender to fix his rate for five years, and was able to secure a two year extension to push the balloon to 2014.

Fast forward to 2013, at which time the original 10-year CMBS loan was open to prepay during the last 6 months of the loan. The borrower cross-collateralized both phases of the development into one large CMBS loan on the full 110,000 SF. The rate was fixed for 10 years at a very attractive rate, eliminating any interest rate risk for the next 10-year period. Furthermore, the CMBS loan was non-recourse in nature, eliminating any risk to the borrower's personal assets. At this time the borrower was able to cash out additional equity from this project to use for other investments, and the process continues.

While traditional construction financing offers a viable outlet for those looking to expand their existing facility or develop a new self-storage facility, it is important for self-storage owners to always be looking at the merits of alternative options. A CMBS debt execution may allow more flexibility to achieve the same development objective while eliminating a significant portion of risk in the process.

Casey McGrath is an associate vice president with The BSC Group, where he provides mortgage brokerage solutions for self-storage clients. To reach him, call 312.878.7561; email cmcgrath@thebscgroup.com; visit www.thebscgroup.com.

Mini-Storage Messenger August 2013

This article has been reprinted with permission from Mini-Storage Messenger.

The BSC Group has been voted Best of Business - Finance for five years running by the readers of Inside Self-Storage.

ISS Best of Business 2015 Award