I recently moderated a panel of financing experts at a self storage convention and have had an opportunity to preview Neal Gussis’ financing article for an upcoming Inside Self Storage issue (don’t miss this article!). It is now clear that many "new" lenders, i.e. the conduit lenders, are out of the self storage business and as a practical matter, so are the life insurance companies. The halcyon days of low rates and liberal loan to value ratios are likely over.

Banks are currently the primary source of self storage financing today and, of course, not all banks are well informed about, or inclined to, the self storage industry. Many of the banks learned about self storage because of a relationship with a self storage owner and thus educated themselves to accommodate their current customers. Bank financing tends to be local as well as relationship oriented and somewhat conservative on loan to value ratios and other terms. However, despite its limitations, loans are currently available in the 9.5% range for terms of five years.

The impact of this narrowing and tightening of the financing market has obvious impacts on sellers and buyers, as well as owners wanting or needing to refinance. The fact that the non-recourse lenders are no longer active means that the ability to get loans for self storage has probably as much to do with the borrower’s relationship to the banker and their net worth, than the quality of the property. Not only does this circumstance reduce the pool of potential purchasers, it also increases the negotiating power of a purchaser with the requisite relationship and net worth. For the present, this situation is not a crisis as there are still many qualified buyers in the market, but they are becoming more selective and rigid in the negotiations. As for additional refinancing impacts, refer to our previous Market Monitor article ("Financing in a Changing World" October 1999, available on our web site www.selfstorage.com, or call 800-55-STORE for a copy).

One form of financing in which the seller has absolute control over the terms is self financing. This is where the seller finances a part of the purchase price in return for interest and principle payments and a security interest in the property. This financing technique doesn’t work for everyone. In fact, if past experience is any indication, very few sellers take advantage of seller financing. This is largely a factor of existing loans that must be paid off. We believe that seller financing, while not appropriate for the majority of sellers, could be used effectively by more sellers than currently do, but are simply unfamiliar with how to use this technique. In general, seller financing broadens the buyer pool, lets the seller set the terms of his cash flow and may have some tax benefits. It also has some negatives. First, of course, is that you don’t get all cash. Also, the seller is dependent on the purchaser’s ability to operate the property, with the result you could get the property back to operate. Determining the applicability of seller financing should be collaboration between you, your accountant and your broker to make sure that all of your objectives are achievable in the market place. Given these general introductions, lets look at some details to see if seller financing is for you.

While each deal is different, a prototype transaction might have a down payment of 30% with a loan amount of 70% with interest rates roughly comparable to bank rates. The term of the financing is usually five to seven years with an amortization of 20 to 25 years. However, each transaction is different and reflecting the method’s flexibility. We will explore the variations on the theme below:

Down payment: Unless there is a very strong personal guarantee, we recommend that the 30% down payment not be reduced significantly. A larger down payment reduces the number of buyers. A good test for determining the amount of the loan and thus the down payment is "Would I be delighted to buy property for the loan amount?" You might get the chance!

Interest Rates: The interest rates should be competitive with other financing available. High rates are not usually salable and if agreed to, often place an unrealistic burden on an unrealistic buyer, not a good combination. Rates at less than market are occasionally offered for special situations. One such example of circumstance could be where a new addition has been added and is leasing up well, but has not achieved projected cash flow. The lower interest rate for a period of time may compensate for the lack of current cash flow, but allow the seller to get value out of the addition.

Term: The term of the loan may have as much to do with your own objectives and estate planning as those of the seller. For example, you may be funding a charitable remainder trust and want a longer term rather than a shorter term or to simply defer the capital gain tax.

Security: A seller must have a security interest (first mortgage) in the property and should obtain a personal guarantee for at least part of the loan even if the borrower has few other assets. Not only does the personal guarantee provide another source of repayment, it can also make a foreclosure simpler. You should also require the borrower to give you annual financial statements and other operational information on the property.

A Note on Second Mortgages: Second mortgages are very complex and often have "unintended consequences" that were never anticipated. One major problem is that in the event of default the seller is responsible for the first mortgage. Occasionally a second mortgage may be used in a special situation, for example, securing excess land to be taken down at a later date. Many first lenders do not allow the purchasers to have a second mortgage. A seller should have a very good reason to take a "second" and understand the risks.

Taxes: Taxes may well be one of the most significant benefits of seller financing. In general, if you are a "cash basis" taxpayer your gains will be recognized for tax purposes as the principle is received (check with your accountant as your circumstances may be different). This has two potential benefits: First, you may be able to earn interest on a larger "net of tax" amount. Secondly, because the tax is collected on the principle portion of the amortizing payments (which are small at the beginning and larger at the end), the net present value of taxes may actually be less. (See box)

Purchaser: With a seller financing it is very important to know your purchaser since you have a contingent interest in the property. The purchaser should have experience and a good reputation – check the references! Remember that you are financing an investment and not someone’s dream.

Liquidity: Although we believe that it usually isn’t prudent to enter into a seller financing transaction with the intent of immediately selling the loan, it is possible to sell loans later. There are many buyers for loans and depending on the stability of the loan, the interest note and other factors the loan can often be sold on favorable terms. The market for such loans is not well organized so shopping around is a necessity. A good note can also usually be collateral for a loan if cash is needed.

A seller financed transaction may have advantages to a seller including a larger buyer pool, tax deferments and possibly a net present value (NPV) reduction of total taxes, ability to invest "proceeds" at a relatively high rate and have some future liquidity. However, seller financing is not a panacea for all sellers and has many risks. It is very important to be clear on your objectives and to get a lot of professional advice before entering into a seller financed transaction.