Seeking Your Next Construction Loan
The desire to develop new locations is typically fueled when prices to buy existing facilities surpass replacement costs for a location and where a new facility is projected to generate a superior return than the alternative of buying existing properties. The projected return to build a new property also needs to be deemed worthy and financially rewarding of enduring the long development and lease-up cycle for self storage.
During the pandemic, the self-storage industry benefited from lifestyle changes, such as working or schooling from home and hybrid office models. These shifts created more demand and spurred rental increases at a faster pace than in the past. There was a surge of new development during and after the pandemic because the market and economics seemed to support the growth.
The consideration to build today needs to account for new supply that has been delivered in the past few years coupled with weakened demand partially attributed to the lack of residential moves and a return from the elevated demand needs during the pandemic years. Currently, discounted street asking rents are prevalent in markets nationwide. To compete for new customers, there is fierce competitive pricing. For existing facilities, the offset of the discounted street rates is the ability to retain existing customers with rates that are considerably higher and have a high propensity to stay an existing renter.
When considering current self storage operating dynamics, the rising cost of material, labor, and capital, development projects may just not pencil out. However, if a project meets your investment criteria, you’ll need to set sights on securing financing. Most developers seek construction financing near the end of permitting and where construction is planned to start in four to six months.
Underwriting Hurdles
For starters, lenders are going to fully need to understand the financial aspect of the construction loan including a detailed breakout of the project costs and the pro-forma operating income. The feasibility and economic analysis need to present a clear path that the loan can be supported by sufficient Debt Service Coverage (DSC – defined as Net Operating Income (NOI)/principal and interest) once stabilized to support the proposed loan terms. The stabilized NOI will also need to support a required minimum stabilized Loan to Value (LTV).
Expect that a construction project will be heavily underwritten and scrutinized. It is not necessarily because lenders are unwilling to lend on self storage. In fact, it is a preferred property type by many; it is more of an issue of understanding the current supply coupled with a longer timeline to construct, higher costs to construct, and the achievability of projected rents. Also, as self storage continues to gain operating sophistication, lenders are much more willing to only lend to experienced and proven developers. You should be ready to provide a presentation that will provide an excellent overview with compelling operating results that support a development loan request.
Location and Proposed Building Plans
You will need to provide the essential physical aspects related to the development plan painting the picture of your vision for the project. Among the items that you will need to provide are architectural drawings, elevations, renderings, municipal approvals, permits, zoning information, and the progress and timing of each. You will want to highlight the reasoning behind why the site location is desirable and how the project improvements and amenities will allow the facility to compete well within its market.
Market Drivers:
Significant analysis must be presented related to the market drivers that support pricing and lease-up projections. Depending on the location of whether the project is located in an urban, suburban, or rural area, the local demand drivers for the surrounding area and users are usually identified in a 1, 3, and 5-mile radius. Given the geographic layout, the surrounding market needs to be customized based on natural barriers, traffic flows, or consumer patterns.
Engage with industry data providers that can provide data on competing properties, those under construction, and those identified in the planning stages. That data should then be used in a supply and demand analysis. There are many methodologies and theories used in determining market saturation and the demand for additional supply. In addition to competitive property information, the data providers should be looked to provide rental data. As good as the data providers may be, local markets have their own nuances which are rarely captured by such providers. Developers should also perform their own market analysis, which may include operating results from other managed locations.
Construction Budget and Proforma:
The key element to a development loan request will be the cost summary. The construction budget needs to include the cost of land, soft costs, site work (and off-site work if required), hard costs, and timeline of construction. Given the rising cost of materials and labor, expect lenders to dig into the construction budget and how to mitigate risks caused by cost overruns or construction delays. The developer needs to build an ample contingency line item. A construction timeline of costs and activities through a Certificate of Occupancy will be needed for the lender’s review.
You will also need to provide a monthly projected operating budget through lease-up which includes the proposed unit mix, unit pricing, and monthly pro-forma operating budget of revenue and expenses. Lease-up projections need to account for discounted asking pricing. It cannot be assumed that units will be able to be rented above asking rates. Only upon a length of stay from existing customers can some level of increased rental rates be achieved. Essentially, lease-up is a two-level tiered analysis, the first being the physical lease-up projections at lower economic occupancy performance followed by a second tier of leasing that focuses on moving existing customers closer to achieved market rates for a seasoned facility.
The larger the facility, the more time you should seek for an interest-only period to not only lease up the property but to burn off concessions. It is very conceivable that a 100,000 net rentable square feet facility could take four years or longer to fully stabilize from opening.
The budget should also include an interest reserve sufficient to service the loan during construction and cover any operating shortfalls during the initial lease-up period up until the property cash flows are at a break-even point. Also, there should be a contingency factor in the reserve to account for some level of inaccurate budgeting of rental rates or timing of lease-up.
Many operators look to develop the pro-forma lease-up in consultation with other industry professionals, namely feasibility consultants and third-party management companies. Third-party management companies have access to a vast amount of national and local information that allows them to create pro forma modeling in the most accurate fashion.
Ownership and Construction Team Qualifications
Banks lend on the premise of a relationship. Initially, the lender will look at the financial and operational strength of the ownership as well as if the ownership fits within the bank’s business footprint before they even start underwriting and evaluating the viability and strength of the development project. The banker will initially focus on the individual(s) who will be responsible for the project completion, management, and repayment of the loan. You should be prepared to provide sponsorship balance sheets, real estate schedules, and tax returns.
The willingness to provide meaningful deposits will provide a better chance of having a positive response from banks. Some lenders will require some level of deposits to even be interested in providing terms.
In addition to highlighting the sponsorship, it is also important to introduce the proposed management, the general contractor, architects, engineers, and other construction team members.
The Structure of the Construction Loan
Regardless of the type of lender, loan terms will be based on the maximum percentages of Loan-to-cost (LTC) and stabilized Loan-to-Value (LTV). The loan terms will require the borrower’s equity portion to be expended before funding the construction loan. Many times, the equity portion is satisfied with the cash infusion for the purchase of land and cash paid for soft costs. Construction loans will include draw mechanics for which proceeds are released as construction work is completed.
Construction loans typically have an initial interest-only payment period. The project should start cash flowing above interest-only debt service at some point over 60% and at an amortizing basis of 70 to 80% stabilized occupancy. Upon certain operating hurdles, most construction loans convert to an amortizing fixed or variable rate permanent loan.
The total loan amount will also account for a reserve for the cost of interest sufficient to service the loan during construction in addition to covering any operating shortfalls during the initial lease-up period. It is important to build a contingency cushion into the loan reserve in case of a change of interest rates or in case the lease-up projections are not met.
The interest rates for construction loans are usually floating and are often based on the Prime Rate or SOFR (Secured Overnight Financing Rate). These indices move directionally as the Fed lowers or raises the Fed Fund Rates, but some lenders will offer fixed-rate options. Interest is charged on only the amount disbursed through the accumulation of the draws.
Typically, construction loans will require full recourse with both completion guarantees and personal guarantees for the repayment of the principal and interest. Some lenders will allow the recourse/guarantee to “burn down” or be reduced at certain occupancy or operating performance hurdles. There may be exceptions where lenders may be willing to reduce or eliminate recourse in instances where LTC is in the 50% range or less or where there may be a larger banking relationship with the sponsorship. It should be anticipated that, in all cases, completion guarantees will still be required through a Certificate of Occupancy.
There are many factors to consider when evaluating and comparing construction loan terms among interesting lenders. Beyond the rate and loan amount, the developer needs to understand other items, such as how development fees are paid out, the construction oversight and draw process, and on-going loan covenants and reporting requirements.
Seeking Lenders
Local and community banks and some credit unions are often the most receptive and best equipped to offer conventional construction loans for a proposed development since they often have the edge in understanding the local real estate market dynamics and the nuances. They may also have familiarity with the sponsorship group and the assembled development team. Banks, in general, are selective in offering development loan terms given two factors:
1.) Trying to manage the risk profile of their commercial real estate lending balance sheet
2.) The overall challenges in the self-storage market as discussed prior.
Always start with your banking relationships to have the opportunity to provide acceptable terms. If you need to go beyond your current banking relationships, finding construction debt will likely involve reaching out to a broad group of lenders which may include local and regional lenders and national banks or nationally active SBA loan providers. The size of the bank and the size and type of loans they make will also have some influence on their interest level.
For a conventional bank or credit union construction loan, the terms may vary widely based on the size of the loan, the projected economics, banking relationships, the financial strength of the sponsor, and other factors such as the proportional size of a depository account.
A lender offering a construction loan under the Small Business Administration (SBA) will offer under the 7a or 504 program. The SBA-offered loans are structured to provide higher loan proceeds than conventional bank loans and need to comply with SBA program guidelines. Costs and interest rates will likely be higher compared to conventional lending terms and are also fully recourse.
SBA loans may be a good option for operators who have less experience or who may want higher leverage. You can seek to obtain an SBA loan either as an SBA 7a or 504 loan. Each has different advantages and disadvantages to consider. There are many specific details relating to both SBA programs, and each has specific qualifications for self storage loans. It is advised to pursue working with an SBA lender that has both expertise and experience in self storage.
A 7a loan typically can be up to $5,000,000, and some lenders can provide an additional conventional loan to increase the total loan amount. The 7a loan would likely be structured as 3-years interest-only (typically allowing one year to build and two years to lease up followed by an amortizing loan (up to 26 years). The 7a loan is fully funded by the lender (and 75% guaranteed by the SBA).
The 504 loan provides for a weighted average interest rate as it is made up of two components: it is funded 50% by the lender with a fixed rate for 25 – 30 years, and 35% is funded by a Certified Development Company (CDC)– an SBA regulated non-profit organization. The second loan is fixed for 20-25 years. SBA loans require personal guarantees under either program.
There are also a limited number of capital sources, typically non-bank or private funds, which provide non-recourse construction loans. Oftentimes, these lenders look to fund loans in excess of $10 million and will charge higher interest rates and points.
At the End of the Day
Undoubtedly, securing a site, putting together the ownership group and the development team, obtaining the necessary permits and approvals, and financing the project are not for the faint of heart. Even if it may be more challenging to build today compared to times in the past, there will continue to be a need for new storage facilities. Construction financing can still be secured, although you may need to look harder, talk to more lenders, and do a bit more homework. Given that you have done your homework and the project is a success, the rewards of your time and hard work will be well worth it.
Keep in mind that some owners choose to work with finance advisors/mortgage brokers who routinely advise clients and work for them to secure financing, whether for construction, acquisition, or refinance needs. With the challenges that the current market presents, it may suit you well to seek professional assistance.
Neal Gussis, Executive Director – Capital Markets, SPMI Capital. The ability to pivot, understanding change, staying informed and connected are keys to longevity and success. Being involved in the self storage and capital markets for over 30 years, Neal has arranged debt for hundreds of transactions for the benefit of self storage owners nationwide and internally for Strat Property Management, Inc. SPMI Capital is a division of Strat Property Management, Inc., a fully integrated commercial real estate management, investment, and consulting company and one of the largest self storage operators. Neal can be reached 847.922.3750 at ngussis@stratprop.com.