October 1999

By Michael McCune
Argus Self Storage Sales Network

In the early days of self-storage, financing was a major issue. A request for a loan was usually met with, "You want us to lend money on garage doors? You must be crazy!" It has taken a long time for conservative lenders to adapt to underwriting this "unusual" form of real estate. Fortunately, as the industry has grown and become more successful, lenders have become more plentiful and more eager to lend on self-storage.

Over the last couple of years the stars have been aligned just right and made the world perfect for financing (except for one blip last fall). Self-storage interest rates fell to record lows, spreads declined dramatically, and lenders were lining up to get into the business. To top it off, the value of most facilities increased because of rising rental revenue and lower vacancies while the industry as a whole was growing rapidly. Financing and refinancing projects was relatively easy.

While not wanting to sound like "Chicken Little", this time of "perfect scenarios" may be starting to change to something less than ideal for owners that may want or need to refinance and buyers looking to leverage purchases. First, interest rates and spreads have gone up, with the combined effect on self-storage loans being about two percentage points above the rates seen a year ago. Secondly, we have seen many of the lenders that were getting into the business now leaving (this relates to the blip last fall). Only two lenders remain a strong part of the industry compared to the four or five seen 18 months ago. Finally, as we reported in the last two editions of the Market Monitor, overbuilding has become an issue in many areas of the country, with concern over vacancies and rental rate discounts/decreases increasing. Clearly, the ability to obtain the necessary financing is dependent on rental revenue and vacancies, which affect the value of the property.

Thus, as we enter this time of change in both the financing and self-storage market, we are encouraging our clients to do a little planning ahead regarding their financing situation. If you have a financing "event" that will occur in the next two or three years you may want to accelerate your action to take advantage of the current financing environment. Many loans have now been in place long enough that the due date is beginning to appear on the horizon. Additionally, many of the "lock in" provisions may have expired and created flexibility for the borrower. While things are not as good as they were 18 months ago, they still are better than they could be in the volatile world of finance.

Playing with some numbers may show why completing this exercise sooner rather than later is so important. Let's take a sample project that is worth about $1,000,000 and has a $750,000 loan balance due in 18 months. The current financing environment is at 8% with a 25-year amortization and a 10-year term while the facility is getting revenue of $150,000 and has expenses of $50,000. However, the owner decides to wait six more months and the environment changes and rental revenue is down 5%, occupancies are down 5% and the interest rate is up to 9%.

Well, this is not a very happy scenario. The cash flow has been cut by two-thirds because of a 10% drop in revenue and a one- percent increase on the loan. Yet, this isn't the worst of it, because you probably could not borrow the full $750,000 again! Lenders always look at something called the loan-to-value ratio and it is generally about 75%. In the original deal the ratio was perfect. Let's take a look and see what happens now.

As you can see these numbers are very sensitive to small changes in revenues and interest rates, particularly if your project is highly leveraged. Our example would require the owner to come up with about $112,000 - just to renew the loan at the higher rate. Not good news when your cash flow is down.

The moral to this story is that while no one can predict the future, we believe that both the self-storage market and the financial markets are going to make financing and refinancing more difficult in the future. Now might be a good time to lock up a "workable" financial package, which would alleviate any major problems if the market worsens when the loan comes due.

While many think interest rates will go down and that rental revenue and occupancies will continue to go up, the evidence in the short run tends to point in the other direction. The FED has raised interest rates twice this summer and what about the new competitors in your area. Please, do a little "What If" scenario for your own facilities based on the model above. Try it with several different combinations, including current conditions and see what the levels of risk are for your own situation.

Speaking to a lending specialist wouldn't be a bad idea either. While Argus is not in the financing business and do not take referral fees, we can give you the names of some reliable lenders.