Texas SSA Magazine – August 15, 2016
While Texas oil fuels millions of vehicles daily, the capital markets have been fueling up the state’s extraordinary self storage facility development and expansion in recent years.
There are three ingredients to any successful storage development project:
- The dollars and cents of development must make sense compared to buying existing facilities.
- Financing must be available. For the past two years, banks have eagerly supplied construction financing for qualified owners promoting feasible developments.
- Prices must support the cost to build. Investor interest in Texas self storage has created an imbalance with demand outpacing supply. Cap rates are at historic lows and driving existing facility prices to record levels.
There’s a storage feeding frenzy today throughout Texas’ major metropolitan and suburban areas, as well as some rural locales. Historic operating performances of properties and their net operating incomes (NOI) are near peak levels thanks to strong occupancies and higher rents. Concurrently, investors ranging from institutional to smaller owner/operators are clamoring to invest so they can profitably fuel up on these market conditions.
Tremendous Financing Alternatives
Texas storage owners have enjoyed tremendous financing alternatives recently thanks to local and regional banks providing aggressive variable- and fixed-rate loans. For example, some banks are using swap products to lock in current low rate loans for three, five and sometimes as long as ten years. Others offer variable rates that provide owners with a low floating rate with an option to lock later should rates creep up. Some banks are also lessening the loan recourse, or guarantee, provisions and eliminating recourse at lower leverage levels.
The banking industry has also embraced storage development throughout Texas. Experienced, well-capitalized operators can now readily access construction and mini-perm financing for their developments. More aggressive construction loan terms feature up to 75% loan to cost, low floating interest rates with interest-only periods through the construction period, and options to convert to a permanent loan following the lease up. Many of these programs include operating and interest-carry reserves.
CMBS loans are also an option for low long-term fixed rate financing. While for years CMBS lenders viewed self storage as inferior to retail, office, multifamily and industrial real estate asset classes, today storage is a preferred property type thanks to its stable industry performance, low historic default rate, lack of exposure to large tenants, and relatively small loan amounts. CMBS offers owners five- to ten-year fixed rates, non recourse (with carve-out exceptions) and 30-year amortization periods, oftentimes with interest-only payments at the loan’s onset. CMBS is the most prevalent form of financing for obtaining significant return of equity beyond initial costs based on today’s values and operating performance.
Cautionary Smoke Signals
While these many financing programs are helping to fuel Texas’ thriving storage market, there are smoke signals owners should carefully consider when seeking lending options:
Changes in Operating Performance:
Despite current high occupancy and rent levels, every storage facility and sub-market will be affected differently by new storage construction developments in their communities. Among other influencing factors are a facility’s relative location, marketing and Internet presence, and local market demand. Even the best positioned properties are likely to experience rent and occupancy pressure with the arrival of new competition. Rest assured, lenders will consider the new developments’ potential economic impact on property performance as they underwrite loans and determine financing amounts.
Interest Rate Changes:
Given fiscal and monetary events in Greece, China and Puerto Rico, as well as sluggish Wall Street earning reports, financial markets have become more risk averse. While world events carry some influence, it is a foregone conclusion the Federal Reserve will soon raise short-term interest rates.
Although storage industry fundamentals remain strong and steady, national and global pressures have created CMBS pricing volatility. Ten-year swap rates have fluctuated approximately 50 basis points recently, with interest rate spreads over Treasury swaps widening ten to thirty basis points depending on the lender’s profitability matrix. The combination of higher Treasuries and higher spreads have caused loan rates to widen by .25% to .75% this summer relative to similar transactional rates earlier this year.
Given potential future interest rate increases and additional competition resulting from new facility development, you might consider using CMBS financing to pull equity from your facility now. CMBS loans are assumable and may be attractive to a future buyer should interest rates spike.
Market Volatility and MAC Clauses:
Every CMBS lender’s application includes a Material Adverse Change (MAC) Clause, whose general language states: “At any time before funding the loan, the lender shall have the sole discretion to modify or not fund the loan based upon factors including the real estate or financial markets that could be expected to cause the loan to become delinquent or to adversely affect the value, marketability or profitability of the loan or securities derived in whole or in part therefrom…”
In practice, this means a lender can adjust the interest rate spread should market conditions materially change after your financing application submission. We have seen CMBS lenders referring to this clause in rare instances where spreads have widened and the lender will, or is likely, to lose money on the transaction. When interest rate spreads recently widened, several CMBS lenders cited that the market materially changed and invoked upward adjustments. Having a mortgage broker help you navigate fluctuating market conditions and lending requirements is very helpful.
Most operators maintain leverage at a 65% to 75% loan-to-value (LTV) level. It’s a risk vs. reward mentality. With higher leverage, the risk increases that the property can adequately sustain its operating performance to cover the debt or decreasing market value. If capital markets continue priming the financing pump, more lenders will tempt borrowers to increase leverage above traditional levels.
While conditions look rosy today, never forget that markets have unpredictable cycles. Many highly successful storage operators learned a painful lesson during the recent financial downturn with poor or untimely leverage decisions. By all means, capitalize on terrific interest rates and aggressive lending alternatives to refinance now, but use caution when determining your LTV leverage and loan amount.
Fueling Up Texas’ Storage Future
The storyline for Texas storage during the next 24-36 months will be the amount of new construction, and whether Texas’ fast-growing economy and consumer demand can support these new facilities.
While investor and financing capital has fueled Texas property values and development, consider assessing your current financing and investment objectives. The state’s growing storage marketplace is not likely to run out of gas anytime soon, but there are indications that the capital markets and statewide storage landscape are likely to see some changes.
With more than 23 years of experience as a national self-storage mortgage broker and advisor, Neal Gussis is a Principal at CCM Commercial Mortgage, where he specializes in securing debt and equity for self-storage owners nationwide. During the past 12 months, CCM has secured more than $170 million in customer financing including securing debt on 14 self storage properties in Texas statewide. He can be reached at 224-938-9419 or ngussis@CCMCommercialMortgage.com.