New construction was one of the biggest victims of the recession. After several years of rapid development-commercial and residential-the financial crisis brought construction to an abrupt halt. As financing dried up, developers were unable to fund new projects. In addition, there was a surplus of new houses and commercial buildings. Many remain empty today.
The self-storage industry, which had been in a rapid-build phase for nearly a decade, was impacted by not only the lack of funding, but also by over building in some cities. Where once a handful of facilities dominated a particular market, there were now a dozen.
Yet there are still markets around the country that are under served, and available land ready for self-storage development. The biggest hurdle now is obtaining financing. New projects backed by solid investors in well-located areas are more likely to receive funding. Likewise, existing properties that have shown consistent occupancy numbers and good returns will also find more favor when refinancing.
In this second of a three-part series, Inside Self-Storage asked experts in real estate, finance and development for their insight to today's market. Our panel discusses how the economy has impacted construction and development, refinancing and cap rates, and what's on the horizon. Our finance experts are:
Weighing in on the construction side are:
Adams: Self-storage financing is becoming more difficult, in part due to the increase in capitalization rates. To exacerbate the problem, many lenders categorize self-storage as a single-purpose loan. The banking regulators also provide lending constraints on this type of product, which limits the amount of capital available to the industry.
New-project permanent financing requires greater leaseup and longer stabilized income to provide cash flow that will support the higher debt-coverage ratios lenders are looking for in today's market. As we have seen in many parts of the country, real estate projects are under stress. Rents are lower, and owners will reduce the rental rate to maintain a project's occupancy. The good news is the tenants stay; the bad news is they pay less money and cash flow goes down.
Hill: The market for self-storage financing as well as all commercial real estate?with the exception of perhaps multi-family properties?is still extremely conservative. Generally speaking, there's ample capital available for high-quality, well-located, stabilized facilities looking to refinance existing debt at 65 percent or lower loan-to-value, with value calculated using conservative (market) cap rates.
In addition to underwriting the property fundamentals, lenders are also focused on the borrower's global cash flow, which includes an underwriting of any other properties the sponsor has an interest in to be sure those are performing as well. There is limited non-recourse capital available; most loans require at lease some level of personal guarantee.
Ragsdale: Lending parameters remain tight, loan-to-value maximum is 65 percent for most, with underwriting to 25-year amortization. For loan terms of three, five and seven years, expect to have the loan "stressed" in underwriting. For example, if your loan terms are 25-year amortization with 6.75 percent interest, the underwriter will stress these figures in underwriting at 20-year amortization with 7.25 percent interest.
Banks continue to ask for deposits at times to counter "naked lending" on commercial properties. Commercial mortgage-backed security (CMBS) loans remains out of reach. Some life-insurance companies are coming back online but tend to focus on other property types. Cap rates are still trending higher.
Adams: The old adage, "Do not put off until tomorrow what you can do today" applies to refinancing your project. If you have CMBS financing and have a loan coming due, you'd better be out there looking to replace that loan as expeditiously as possible. The lender that funded your last transaction probably doesn't exist to fund the refinancing of your property.
The aberration we saw where the cap rates fell through the floor in 2005 and 2006 will not be repeated in the near future. Cap rates today are increasing across the board as investors demand a greater return for taking a real estate risk with their investments.
Hill: First, take the emotion out of the process, because in this environment it's all business. Start early. Loans take much longer to execute these days. Make sure your expectations are realistic and be prepared before you go to the lending markets with the transaction. Work hard to make sure you have premeditated the weaknesses in the deal and mitigated those up front.
If you get a proposal in hand that works with a lender you can trust, execute the transaction. Do not get greedy. Certainty of execution is paramount, and trying to gamble on an unknown entity under the allure of a more aggressive deal, or to save a few basis points in interest rate, is simply not worth the risk.
Remember, we're in a capital-constrained environment with many deals chasing the limited dollars available, and it all boils down to your basic beauty contest. Make sure you pull out all the stops to look as good as possible before the big show. If this is not something you feel you can accomplish by yourself, hire a qualified professional to assist you-it will save you time, money and, most likely, frustration in the long run.
Ragsdale: Start early, be flexible and realistic. Understand how cap rates are impacting your values. Focus on the bottom line. Every dollar of net operating income is keenly important now more than ever.
Adams: New construction is at a virtual standstill in most markets. The only new-development financing available in the near future will be for projects that have excellent economics, which will be created by strong capital contributions from experienced operators with strong balance sheets.
While it's not a federal banking requirement to have a feasibility study, smart lenders will require a more in-depth analysis of your project. Remember, the real estate lending debacle has not just been subprime home loan borrowers, but commercial real estate development providing more capacity than the market was capable of absorbing.
Hill: There's always an exception, but for the most part, there's no debt available for new construction at this time. Lenders are busy finding solutions for the problems that already exist on their books and, therefore, maintain a risk-adverse mindset toward anything with the potential to create new problems. Construction loans by nature are speculative and more risky than refinance transactions, which have cash flow in place to service debt and an existing track record of loan performance.
If you're looking for new development-type returns but are having trouble finding a construction loan for a new project, consider shifting gears and looking for a distressed development deal that already exists. Under this scenario, you may be able to motivate the lender by acting in concert with them. You'll assume some level of existing (likely modified) debt that's already in place and contribute new equity to help "right size" the deal, creating an opportunity for yourself and helping the lender solve a problem at the same time.
Ragsdale: Build a relationship with a local bank that has done construction deals in your area. Be prepared to send large on-demand deposits to the bank in exchange for development funds. Third-party reports on feasibility must show a high degree of demand for your project. Also, be prepared with a high net-worth partner on your deal who's willing to personally guarantee the loan.
Adams: As we move into 2010, the real estate market for new housing should begin to improve. Inventory levels are down, and home builders have built few new homes over the last several years. This improvement will have a positive impact on the self-storage market and significant benefits to the banks by helping to eliminate their real estate owned (REO) portfolios.
A significant number of banking institutions were poised to write off all the bad real estate in their portfolios by the end of 2009. Hopefully this internal cleaning of the books will allow new loan allocations, which will benefit the self-storage industry. Make no mistake about it?your project will have to be well-underwritten with significant equity contributions from the sponsors and strong balance sheets to get your project financed.
Hill: For the most part, self-storage has performed well in this recession, and the financing challenges owners face are no different from those of other commercial-property owners. Nonetheless, the commercial real estate financing markets continue to face some serious headwind. Property fundamentals are being challenged and asset values have declined, in many cases eroding significant equity in the transactions.
This year will likely be challenging for real estate financing, as the capital markets for securitized lending products attempt to regain some traction, and the major burden for real estate capital is placed on bank and insurance company balance sheets. Simply put, there's just not enough capital available at the bank level to refinance all the upcoming maturities, not to mention the loans that have already matured this year and extended one or two years. Banks will likely become more aggressive in foreclosing on properties that are not performing and do not service debt if the sponsor cannot re-capitalize the deal.
The outlook for our industry in the long term is promising under the theory that self-storage loan performance will have, once again, proven itself during this recession. The lending community will gain additional comfort with the performance of the asset class as a result of this recession.
Ragsdale: Self-storage will remain a small piece of the overall commercial lending realm, therefore, little attention will be paid to it. Self-storage is being impacted by the fall of other property types and the constraints on credit far more than the property type has been impacted by the economic downturn. Banks that have a special interest and knowledge of self-storage will remain attractive options.
Campbell: Slow. People are either afraid to make the commitment due to the economy or, if they do want to build or expand, financing seems to be one of their biggest hurdles. If they're able to get financing, the terms are favorable.
Wright: Challenging. Over the past 18 months, we've seen a significant slowdown in ground-up construction. That being said, it's the opinion of many experts, myself included, that if you have a site that would lend itself to a new facility ... what a great time to build! Overall construction costs are the lowest I've seen in 15 years.
Campbell: Financing seems to be the biggest hurdle from the builders and developers we talk to.
Wright: Without question, it's the ability to obtain financing. We're living in an imperfect world when it comes to lending. Bottom line is that many banks are just not willing to take any risks with ground-up construction. My advice is to be persistent and patient with the banks. There are still many of them out there that have an appetite for ground-up construction.
Barry: There are many fully approved sites for self-storage on the market today. The lack of development financing has virtually closed this market for the time being. For the same reasons, we suspect fewer investors will begin the land-development process until some of this supply clears the market.
Chiswell: There's no question that we have a much more competitive environment, but there are still sites that could be developed. I know several owners with uniquely attractive locations that will be built in the year ahead. Anyone looking to develop a site is under increased pressure to have a very detailed loan package with an independent feasibility study.
Kliebenstein: Yes, and at better prices than in past years. With a weakening market, land owners are not quite as proud of their overinflated values as they used to be. More realistic values are being driven by cash buyers who can be selective in taking down only the land purchases at drastic discount or at hyper premium locations.
Buyers and sellers can also look to potentially softened hearts at the municipal level as well. As tax bases drop with declining values and development continues to be absent, cities and towns may become more open to development, which leads to employment, a property-tax base and, in some venues, gross-receipts taxes. Municipalities are cutting back on expenses like salaries to meet declining budgets, and eventually, that may equate to relaxing some restrictions on building and development as they look for ways to generate revenue.
Vestal: Land for self-storage development is very plentiful, with several pieces of land with city approvals in hand just sitting stagnant and likely to stay that way for several years. With the availability of construction financing being almost nonexistent, it has made these pieces of land almost worthless in today's market.
Wilson: Yes, there's land available and it probably costs less today than it did a year ago. However, self-storage, like all other property types, is at the bottom of the real estate cycle, and that means the real opportunity today is in acquisitions, renovation and remolding. Construction financing for new starts will probably remain tight for some time.
Campbell: It will to a degree. There has to be a happy medium there, a return that's acceptable. For example, solar panels are not cheap, so there has to be a realistic return on investment that will make it feasible for the builder. Insulation R-values and similar things will play a bigger role. Most everyone would like to be greener, but unless there's a payback, most aren't going to be green just for the sake of being green.
Barry: It's typically less expensive to convert a building to self-storage than build from scratch, plus there will be plenty of properties that may be acquired at deep discounts. I would expect to see this segment be one of the first areas developers seek out when financing improves, especially in urban areas.
Chiswell: Many property owners sitting on empty "big box" retail stores that have gone dark are considering self-storage as a possible alternative. However, I caution these owners to pay close attention to the internal travel distances that could result from the conversion. Access for unloading typically can only be designed in one location, and many times it's around the back of the building with no visibility to potential customers. The resulting travel distances can be 250 to 400 feet. Once you get beyond that 150- to 200-foot travel distance, potential customers feel the space is inconvenient. Owners are increasingly being forced to discount these distant units beyond the upper-floor discounts already in place.
Kliebenstein: Conversions have always been a great development tool. With businesses closing, higher foreclosures and weakened economic prospects, more buildings will become available for conversion. If the municipalities relax retail zoning standards and see self-storage for the valuable contribution it makes to a community, greater numbers of conversions may become possible.
Vestal: Over the next few years, well-located urban conversions may be the only new development of self-storage facilities. This is because of the high barriers to entry that some highly dense urban locations offer to developers that will bring the risk/reward in line with some self-storage developers' risk tolerance.
Wilson: Absolutely and without question there will be conversions, restoration and modernization of older facilities. Now that the level of supply has satisfied pent-up demand, the free ride that many first-generation facilities have enjoyed is over. Those poorly located facilities that have functional incurable obsolescence will be razed, and the land will be put to a higher and better use. Well-located facilities of inferior construction quality or those that suffer some curable obsolescence will undergo restoration, renovation or modernization, or they will be razed and replaced with a modern facility.
Campbell: That's a great question. Between fears of the economy, lack of financing and steel prices that keep changing, it's anybody's guess. But we are being optimistic and doing everything we can to find and work with anyone who's willing and able to build. The ones who build now will have a leg up once things turn around.
Wright: The future for self-storage development this year is positive. We have many clients with sites that are ready to go. Grant it, a few things need to fall into place, but without question there's opportunity out there. I see a general consensus among developers that they're still very eager to build. Right now patience is the name of the game. It's important to touch on this again-construction prices are the lowest I've seen in 15 years. Do your proper due diligence on your parcel and take advantage of these costs!
The BSC Group has been voted Best of Business - Finance for six years running by the readers of Inside Self-Storage.