By Neal Gussis
Most owners have first-hand experience in some form of real-estate financing, starting with construction and development loans. For the past few years, there has been an unprecedented amount of construction and development financing available at rates that make investment returns attractive. We've also seen a vast array of permanent financing options that were just too good to pass up. Undoubtedly, the financing markets in recent years have opened the door to rates and terms not seen before in the industry.
Yet with the financing bonanza comes new lender expectations. The days of loans by handshake are well past us. At today's financing store, lenders look at all aspects of the transaction prior to committing and funding loans. There are also new terms and conditions that are new concepts to borrowers. The financing activity flurry started to slow down in the past 12 to 18 months as interest rates increased and underwriting standards adjusted. We have also seen significant changes in who is lending in this marketplace.
So with all our experiences, there's only one thing we can do, and that is move forward. We're all better informed and able to match our business financing objectives with available lenders and programs. And, although the financial marketplace constantly changes, owners are now in a better position to control their next financing transaction.
Let's take a look at your options at today's financing store and see what makes sense for your property needs. As you know, leverage or debt comes in many forms. The most commonly sought loans are construction and permanent or end-loans. For owners with larger property portfolios, you can obtain higher leverage through mezzanine debt and equity participation programs. Let's focus on construction and permanent financing and look at who we can turn to for our next financing transaction.
Banks and Savings & Loans
Banks and savings and loan associations have traditionally been the largest self-storage financing source. However, most have ceased to exist. Bankers generally like to lend on transactions with which they have a wealth of experience and the credit decision can be easily supported. However, self-storage understanding varies dramatically among banks based on the loan officers' and credit committee's exposure to our industry. The bank's loan committee also must understand that although self-storage properties do not have long-term leases, future operations can and will be stable. As the self-storage industry has grown and matured, more banks than ever are considering self-storage loans for their portfolios.
Many bank loans are "relationship" loans. What this means is that much of the credit decision is based on the strength of the borrower and past banking transactions. Traditionally, most bank loans have been recourse or partial recourse. Banks generally hold the loans they make in their own portfolio. This gives them more flexibility to negotiate loan terms. In some cases, even more importantly, they can modify loan terms even after the loan closes. If the bank intends to keep your loan in its portfolio, you will have the benefit of lower closing costs since they may have fewer third-party report requirements. Also, a bank's loan documents are typically less complicated and onerous than those of other lenders. Banks will also oftentimes waive "capital reserve" requirements.
Local banks are still one of the only sources for construction financing. The local bank is best equipped to understand the local real-estate market's dynamics. These loans are typically three years in term, and are designed for helping the borrower through the construction and lease-up period. Construction loans are recourse loans requiring personal guarantees, and are generally "interest only" with no principal pay-down for the construction loan period. Many banks will provide a mini-perm that allows the borrower to roll his loan into a permanent or end-loan. These loans will generally have a 20- to 25-year amortization with varying term lengths, although a five-year term is most common.
The banks are still the largest providers of end-loans or permanent financing. For loans under $1 million dollars, banks are the primary funding source. Typical loans have five-year terms with a 15- to 25-year amortization period with minimum debt service coverage (DSC) of 1.30 to 1.35 to 1. The maximum loan-to-value (LTV) varies; however, it typically does not exceed 70 percent. These loans can be recourse or partial recourse. The interest rates they charge are generally not the most aggressive, but if you have a "relationship" and keep deposits or have other loans with the bank, you may have more leverage to negotiate a better deal.
One of your newest options in financing "stores" is a hybrid of banks and conduits. Many banks have the ability to provide securitized loans. In this scenario, they will provide the same terms offered by traditional conduits or Wall Street capital sources. They are able to fund the loans from internal capital. Based on the market, the banks then have the option to sell the loan to be securitized on Wall Street or keep it in their portfolio.
Conduits
Conduit lenders provide loans through capital sources. These sources will include your loan in a pool of loans to be securitized through commercial mortgage backed securities (CMBS). Conduit lenders consist of banks, credit companies, Wall Street firms and mortgage lenders that underwrite and close in their name, but simultaneously sell the loan to one of the previous sources at closing. The securitization proceeds then replenish the capital source's outlay for funding your loan. Conduit loans are pooled and sold as debt securities (bonds) to institutional investors. The pooling reduces risk to the bond investors and facilitates the more aggressive interest rates.
Many owners have chosen to finance their properties through securitized loans in recent years. These loans offer attractive financing alternatives to owners seeking long-term fixed-rate financing and who are unlikely to pay the loan balance off prior to maturity. Today, the most popular loans have a 10-year fixed-rate term with a 25-year amortization period. These loans are all non-recourse (with standard carve-out exceptions). As of early September, loans supported by stabilized properties were being quoted at the low to high 8 percent range based on the deal's credit strength. The primary underwriting parameters are generally based on a 75 percent LTV and a 1.30 DSC. These loans consider historic operational cash flow, and most programs will underwrite your loan based on the previous 12 months of operations. Loans on lease-up properties are generally quoted on a case-by-case basis. Securitized loans usually have very restrictive prepayment provisions, but do allow a purchaser to assume the loan (generally for a 1 percent fee).
With owners demanding prepayment flexibility and the ability to increase loan dollars in the next two to three years, many conduit lenders now offer variable rate loans or float-to-fixed deals. The floating rate deals are generally about 1 percent higher than fixed-rate deals. Several conduit programs may not be available since many securitized lenders have minimum loan requirements of $2 million to $5 million.
Notably, the CMBS lending market has been in a "shake-out" period. With decreased loan volumes and profit margins, several lenders have left the self-storage market, including two of the industry's largest. It is likely that others will follow. Industry watchers insist that those who remain will be the stronger players, the ones most likely to remain the dominant lenders for the long haul.
Conduit lenders have little flexibility in their ability to negotiate terms since all loans in the pool need to have similar structures. Although conduit loans still offer the most aggressive loan terms, underwriting guidelines have become more conservative over the past year. The pools are ultimately examined by Wall Street bond-rating agencies and are rated as to the likelihood of default. There is also a growing concern that badly underwritten loans are under deeper scrutiny and being withdrawn from the pools at the demand of riskier bond purchasers (i.e. the B-piece buyer).
Choosing this option entails a trade-off between obtaining a loan with maximum dollars, longer terms, non-recourse and longer amortization periods vs. inflexibility in loan document negotiations and restrictive prepayment penalties. Closing costs are higher than bank loans. Remember, non-bank permanent loans generally have terms of 10 years or more, which translates into fewer costs over time.
Life Insurance Companies
Life insurance companies are portfolio lenders and often the choosiest lenders in the financing store. Typical minimum loan amounts are $3 to $5 million. They also look for facilities built within the last five years that are state-of-the-art and have stabilized operations. They are typically less aggressive with leverage, many times requiring a maximum of 70 percent LTV and 1.35 DSC. The loan terms feature 10-year terms and a 25-year amortization period, and tend to be non-recourse. Since they do keep the loan in their portfolio, life companies can negotiate loan terms, but have limited flexibility since the loans are non-recourse. The good news is that if you meet these requirements and are seeking a lower leverage loan, a relatively aggressive interest rate awaits you.
Mortgage Bankers
Given their many responsibilities in operating their businesses, self-storage owners oftentimes need a specialist who can communicate with lenders on their behalf and get the best deal possible. These mortgage bankers, or loan brokers, understand the market's capital sources, lenders and their many programs. Mortgage bankers frequently arrange with capital sources for the financing fee to be paid to them.
Mortgage bankers play a unique role in our industry at this time. Clearly we are seeing few, if any, lenders currently advertising in the monthly industry publications and a large reduction of lenders exhibiting at our trade shows. The majority of capital sources, including GE and Heller Financial, currently the most prominent self-storage lenders, have limited marketing personnel and look to mortgage bankers to procure a majority of their permanent loan business.
The mortgage banker assists you in preparing a financing package for distribution to likely capital sources. The mortgage banker adds value by preparing a package that tells your story and request in an organized and realistic manner. While we're deeply immersed in our industry, we sometimes forget there are still many lenders with limited self-storage knowledge who need education. Therefore, when choosing a mortgage banker to represent you, you should seek someone with self-storage financing experience.
Mortgage bankers help you cut through the typical delays and mazes of a large lending institution. You may also get better response time, since the mortgage banker and his firm may have done several deals with the lender. The mortgage-banking professional is assuming an increasingly important role in helping owners understand their options and shopping their deals throughout the many stores in the financing mall.
The Internet
Everybody's talking about the Internet as the next big shopping tool, whether you're looking to buy a house or computer or negotiate a loan deal. It's probably the most organic form of retailing available today, literally changing on a daily basis with new concepts and websites.
There are several loan websites that attempt to unite you with lenders offering the best rates and terms. Many people I meet think these sites are valuable for gathering information, but are not currently the answer to their self-storage financing needs. These websites are still at a very early development stage and most likely will go through a "shaking out" period, leaving a limited number of available options.
It is reported that literally thousands of deals are presented to these websites, but only a few handfuls of them are actually closing to date. Also, remember where you might fall in the pecking order of the deals they are reviewing. Many of the deals are mainstream real estate (i.e. office, retail, multifamily properties) with larger loan requests. As these websites improve, they will certainly change the financial landscape and create completely new storefronts for self-storage financing.
Summing Up
While the self-storage financing store continually changes, some things stay the same year after year. Please keep these thoughts in mind as you consider financing:
- Make sound financing decisions based on your short- and long-term goals.
- Choose the lender or mortgage banker best suited to your needs.
- Daily business transactions are generally conducted with people you know and trust, and with whom you have an ongoing relationship.
- Accountability is key, especially on large transactions.
There's no doubt that self-storage financing depends on solid relationships and personal attention. No matter which store you choose for your loan, look for that personal touch in any transaction.
Neal Gussis is a senior vice president at Beacon Realty Capital Inc., a financial services firm that arranges debt for self-storage and other commercial real-estate owners. Mr. Gussis has funded more than 250 self-storage transactions totaling nearly $500 million. He can be reached at (312) 207-8240 or at [email protected].
Glossary of Commonly Used Terms
Understanding your loan application
Amortization--The number of years necessary to pay the loan balance down to zero. This includes principal and interest payments. A typical fixed-rate loan is amortized over 25 years.
Assumption/Transfer Provision-- Most lenders will allow a one-time assumption of the loan subject to the lender's approval and payment of a 1 percent fee.
Debt Service Coverage Ratio (DSCR)--A ratio used to express the relationship between annual net operating income and annual debt service. Most lenders require a minimum DSCR of 1.25:1.00. For example, if the annual debt service is $100,000, the annual net income has to be equal to or greater than $125,000.
Impound/Escrow Account--An account used for the deposit of valuable considerations such as money. The most common use is for the collection of property taxes and insurance premiums.
Index--The instrument used in determining the base for the cost of money. The Treasury rate is most commonly used for fixed-rate loans while the LIBOR index may be used for variable-rate transactions.
Loan-to-Value (LTV)--The percentage amount borrowed in the acquisition or refinancing of a property. The value of the property is determined by a third-party appraiser.
Margin--The spread between the index and interest rate.
Mortgage Constant--An equal annual payment, expressed as a percentage, that will amortize the principal and pay interest over the life of the loan. It is important to look at the application and determine if there is a minimum constant required by the lender.
Prepayment Premium or Penalty--A penalty for an advanced payment on a mortgage. The most common penalty is known as defeasance, which is the substitution of Treasuries for the remaining payments on the loan.
Securitization--A securitization involves a lender bundling similar mortgages that are analyzed by rating agencies and then used as collateral for bonds purchased by institutional investors. This type of financing is ideal for borrowers looking for low fixed-rate financing.
Reserves Account--An account to collect reserves for capital improvements. Most lenders will require that an account be established to collect reserves in accordance with the report prepared by a third-party engineer. In most cases, there will be a minimum collection of 15 cents per square foot, regardless of the results of the engineering report.
Single-Purpose Entity--A requirement by all CMBS lenders, a single-purpose entity restricts the borrowing entity from owning any other facility other than the property being financed.
Term--This is the period of time between the borrowing date and due date. In most cases, the term of the loan will coincide with the Treasury bill. For example, a 10-year loan will be priced over a 10-year Treasury bill.
