The 5P Basics of Self-Storage Construction Financing

October, 2015

Development came back in a strong way in 2014, and based on current activity, the next several years look to be very active for self-storage developers. New activity is supported by a steady economy, improvements in the housing market, access to capital, and most importantly a pent-up demand.

After more than a decade of very little development in the self-storage market, investors are beginning to consider these types of projects to diversify their portfolio. 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 are poised for revival and becoming a thriving opportunity for self-storage developers once again.

The self-storage REITs are also bolstering activity with feverish acquisition activity. They are acquiring newly constructed properties at Certificate of Occupancy, and are also creating joint venture and other partnerships with local developers to construct new projects in their target markets- arrangements that the market has not seen with any consistency since prior to start of the recession in 2008.

There is little doubt that the success of a self-storage construction project can depend heavily on the debt structure, which includes important factors such as the interest rate, term, advance rate (loan to cost) and payback requirements. Ensuring that the developer and the lender have aligned interests in the capital structure will definitely increase the likelihood that projects will flourish.

If you are commencing a project that requires construction financing, prior to engaging a lender, it is critical to understand the basics of construction financing, including the particular considerations specific to the self-storage industry. Being equipped with the proper knowledge and a sound game plan will increase the odds that your project is a successful and profitable venture. Borrowing from a well-known military adage of the 7Ps, we recommend adopting a 5P approach to help you achieve success: after all, Proper Preparation Prevents Poor Performance.

Demonstrating Demand: Do Your Homework

Understanding the market is a critical component of any successful project; after all, if the market is already saturated and there is no demand to lease space, it hardly makes sense to develop. More importantly, prior to approving a construction loan request a lender will require assurance that a borrower has a firm understanding of the market, and that there support for sufficient demand in the market to absorb the new space in a timely manner.

An objective feasibility study is a great way to satisfy this criterion and verify to both the lender and the developer that the project is sound. A comprehensive feasibility study should include the following important information:

  • Depth of the market - Based on the demographics and growth trends of the surrounding area, how much square footage could the bear? How much square footage is currently in the market? Is the market underserved?

  • Location - Is this a first-rate location? Location is the single most important aspect of any real estate development project, and it definitely 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 how long did it take and at what occupancy did they stabilize? The idea that you can simply apply a certain percentage per month and straight-line that out over time seems misguided: after all, projecting lease up of three percent of 60,000 net rentable feet is much different than three percent of 100,000, and depending on what part of the country you are in leasing seasonality may come in to play. It is imperative to critically think about lease up and apply conservative numbers or a contingency to ensure you have properly calculated other metrics like interest reserve and investor returns.

  • Pricing - What is the most likely rent you will receive based on the current 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? Are the properties comparable to what you are building or are they older, more antiquated facilities? What types of operators are present in the market? 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 and investors. Furthermore the type of operator can be both a positive and a negative; REIT's and large regional players bring a sophisticated pricing and management style that can provide stability to a market. By their very nature, however, they also have the size, capacity, and capital structure to undercut their competition to maintain occupancy, which is a luxury the smaller operator may be able to afford.

  • Construction costs - The lender will want to see an analysis comparing your construction costs to industry averages and other units in the area. If existing properties in the area are selling below replacement cost, it may make more sense to acquire rather than 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 are planning to build. Is the parcel properly zoned for self-storage, or will you need to go through a process to obtain the proper entitlements? Zoning restrictions of future development are a major barrier to entry. Being able to quantify potential barriers and associated timing will go a long way toward getting your loan approved.

  • Return on investment - Most importantly, based on all of these factors, including the construction costs, anticipated rents, lease-up rates and other factors, what type of return can you and your investors expect?

Lenders will typically require this "feasibility" study, although the specific scope and level of detail will vary from institution to institution. Some banks may require an independent third-party to complete this analysis, while others will accept one generated by the borrower so long as they feel it is adequately comprehensive. Often times it is a combination where the bank will accept a borrower-generated feasibility study and rely on the appraisal to verify the claims. Regardless, as the developer of the project you will definitely want to have a good grasp on all of these factors prior to seeking financing.

Defining the Opportunity: The Investor Package and Loan Summary Request

Another critical component to obtaining financing is the presentation of the deal to the investment and lending community. This is often referred to as the Investor Package or Loan Summary Request.

Begin your loan package with an Executive Summary that outlines the contents and your desired loan terms. At the very least, the Executive Summary should specify the requested loan amount, length of loan term, interest rate and total project cost. A properly structured construction loan should always include a contingency for unforeseen events, as well as reserves for operating deficits and interest to be paid during the construction and lease-up period until the project exceeds the breakeven point. One can use a lot of the conclusions of the feasibility study to prepare and present that Loan Summary Request.

Following the Executive Summary, there are several other elements to include in your construction loan package.

  • Construction Budget - A construction budget identifying a project's total costs gives a lender comfort knowing you have considered all aspects of the development. The total cost will include the cost of the land and related entitlement costs (or its present value if you have owned the parcel for a long time), hard costs (or the costs to improve the site and build the facility), and soft costs such as legal, zoning, architectural, financing, engineering, environmental, and developer profit.

  • Loan to Cost - This is the percentage of total costs the bank will lend. The general rule is that lenders will require between 25 and 35 percent cash equity in a deal, resulting in a loan to cost of 65 to 75 percent. Some lenders will recognize an increase in the land value as the equivalent to cash for part of, or the entire, equity requirement. This can result from land that has been owned for a long period of time, or land that has been acquired with one zoning classification but has been reclassified to a fully entitled parcel ready for self-storage facility development.

  • Loan Term - Historically, construction loans are for a 24-36 month period, with the expectation that a developer will refinance the loan at maturity. The loan term and next steps following its maturity are very important parts of properly structuring a self-storage construction loan.

    Some construction lenders provide some form of mini-permanent ("mini-perm") or permanent loan after the construction period. On the surface, this may appear to give you greater flexibility at the maturity of the construction and lease-up period. Be cautious that you've factored in potential costs associated with this option as you may be required to convert the loan to a mini-perm with the construction lender or pay an exit or prepayment penalty should you wish to explore other options or sell the property in the future.

  • The Pro-Forma (Income and Expense Projections) - A loan package's most important components are the financial projections, or the pro-forma, that support the economics behind your self-storage facility project. A pro-forma should detail anticipated monthly revenue and expenses from construction completion through lease-up. To successfully obtain a loan, you must demonstrate: 1) the project will be profitable, 2) there will be sufficient income to pay the mortgage, and 3) lease-up will be fast enough to replace the construction loan with a permanent loan prior to the end of the construction loan term.

  • Interest Rate - Lenders traditionally provide construction loans on either a fixed rate or floating (variable) rate basis, generally with an interest-only period. Many lenders price their loan over the current Prime Rate plus some additional "credit" spread, depending on the perceived risk in the project, as well as other factors. Some lenders prefer to price loans over the London Inter-Bank Offering Rate (LIBOR).

    Floating or variable rate loans typically adjust up or down specified period depending on market changes. Be sure your pro-forma and economic analysis account for the effect of an increasing interest rate in today's environment. Currently market rates are historically low and range between 2.5% and 5%, however we always recommend that borrowers use an overly conservative rate and factor in increases over time to ensure that there is adequate interest reserve built in to the analysis.

  • Borrower Information - When preparing a loan request package, include the borrowers' resumes and personal financial statements. Resumes should focus on each individual's real estate and self-storage expertise and experience. Borrowers who are experienced self-storage investors can mitigate many risks a lender may identify. Construction loans typically require full recourse (personal guarantees on the loan) to the owners of the borrowing entity. Thus, the financial strength of the borrower(s) is as important as the project's merits itself.

  • Construction Company Background - A self-storage construction project is more likely to succeed when built by an experienced and reputable construction company with previous self-storage experience. Very importantly, the construction company should be willing to work with your bank and adhere to the lender's construction draw process. In your loan request package, include information on your construction company's expertise and experience.

  • Management Group - Include a clear plan for managing the facility. If you expect to hire a third-party management firm, include their experience in the loan summary package. To a lender, an outside management firm is typically the desired strategy as it gives the bank confidence that those running the facility's daily operations have sufficient self-storage experience, thus mitigating a major risk. If you and/or your partners plan to personally manage the facility, clearly establish your qualifying expertise and experience, including your past work experience and education.

Likely Sources of Capital

Quite simply, construction financing continues to be an area that is dominated by local and regional banks. From a practical standpoint, these lending 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. Regardless, it can be hit or miss as to whether a specific bank will entertain construction financing in general, and self-storage specifically. Given the struggles many lending institutions had during the recession, some are more risk averse than others, and frankly some do not have a lot of experience with the self-storage asset class.

Many construction lenders are "relationship based," which means the credit decision is largely based on the strength of the borrower and the depth of the relationship with the lending institution. This further bolsters the local and regional banks' positions as primary construction lenders, given many local banks are relationship driven by nature.

National banks have also increasingly crept back into the construction financing market; however, these lenders tend to be attracted to larger balance loan and very experienced developers in primary markets. More readily available financing on the national level comes from private lenders who typically charge a yield premium in exchange for higher leverage and access to capital when compared with local or national banks.

The bottom line is that many construction lenders are "relationship" oriented, so a large part of the credit decision and willingness to lend is based on the strength of the borrower and the past and future potential banking relationship between the sponsor and the specific lending institution. If you have an existing relationship with a current bank, it may be the best place to approach initially for a construction loan. After that, try other local banks in the area.

Participating Debt

New programs are popping up that allow borrowers to fund their projects with high levels of debt, up to 90%. In exchange for this higher leverage these lenders are requiring a participating interest in future profits, both from ongoing cash flow as well as any future sale proceeds. These programs generally require Class A projects in major metropolitan areas and third party management. In addition to a limited equity investment these programs offer non-recourse loans, which is very rare for construction loans.

Intermediaries

An efficient way to access capital be it locally, regionally, or nationally is through a mortgage banker, particularly if you wish to consider private lenders, who may be difficult to identify independently. Because few construction lenders market themselves directly to the self-storage industry, commercial mortgage brokers have assumed a much larger role in recent years helping self-storage developers and investors obtain property financing.

Mortgage brokers work with multiple lenders who are familiar with the self-storage property type. With no ties to a single financing source or loan product, self-storage mortgage brokers can search a much larger universe of construction loan programs to help developers secure a loan with the best overall terms, thus saving you money and helping you avoid unnecessary future refinancing costs, which is especially pertinent in today's rising interest rate climate.

Given the increasing complexities and available transactional options in the lending process, specialized self-storage mortgage bankers and brokers have become valuable resources to help borrowers open the door to the best construction financing. Their property expertise and financing knowledge can provide an advantage in securing the most competitive construction loan terms currently available.

Alternatives to Construction Financing

When a borrower's situation is less than ideal to obtain construction financing through an existing bank relationship, or in cases of project expansion, there are a couple of other good sources to consider.

CMBS

Now that Commercial Mortgage Back Securities (CMBS) are readily available again, borrowers seeking construction financing can consider this product to solve two issues at once. A borrower with good equity in a performing property can lock down that asset at record low rates for the long-term, while essentially gaining access to non-recourse loan proceeds on a cash out basis, tax free. The shrewd investor then has the option to either develop using straight cash, or use the excess cash to lower the leverage on a construction loan, thereby increasing the likelihood of approval.

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.

SBA 504

The SBA 504 is a two-party loan program with the ability to fix at least a portion of the debt for up to 20 years. The program does carry a 10-year prepayment penalty, as it is designed for borrowers who have a long hold period, a single use of proceeds (real estate or equipment), or want to build a second location. SBA 504 borrowers also sacrifice flexibility and have limited use of proceeds. The ability to secure long-term fixed-rate debt can outweigh these drawbacks.

The 504 program allows for new construction and leverage up to 90 percent, with specific limitations. The program is best fit for an established owner/operator with the same borrowing structure who is looking to add an additional location. Borrowers adding new partners or without prior experience will have difficulty using this program for construction purposes. Primary location(s) will also have to support the additional debt of the new location at or near a 1.25 to one times ratio. The program can certainly be seen as restrictive. But for borrowers who qualify, they can take advantage of near record-low interest rates at leverage levels that are rarely seen in other lending programs.

Articles: October 2015

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