A Self-Storage Investment Journey – Chapter 5
A Self-Storage Investment Journey – Chapter 5
Where’s the Money?
CHAPTER 4 RECAP
In Chapter 4, I presented a high level overview of the due diligence process which I’m currently winding up for my acquisition. In fact, we have set a tentative closing date of 3/19/21 assuming there won’t be any show stoppers prior to ending my 30 days of diligence. I’ll be on-site next week meeting with inspectors and service providers, as I prepare to take over the operations. In the interim, I thought I would spend some time talking about something that I get asked about several times a week — “How do I buy an asset like this if I’ve got limited personal funds”? Well, here ya go!
** DISCLAIMER** This is neither legal nor financial advice. It’s simply me sharing some knowledge. I could be right, I could be wrong…but it’s how I operate and it works for me.
As I’ve mentioned before, Self-Storage is an asset class that lenders and investors absolutely love! Why? Because they have the lowest foreclosure rates of any commercial real estate class. They just don’t fail. But lenders are good at underwriting and you’ll need to hit certain criteria if you are going to get traditional bank funding. There are some other options that I’ll discuss here as well, and hopefully you’ll find a way that works for you. Just give me a call if you want to talk about any of these options in more detail.
If you are going to finance your acquisition, you’ll need a down payment (unless you syndicate, which I’ll discuss later). Most lenders are loaning anywhere from 70-80% LTV (Loan to Value), which means you’ll need 20-30% of the purchase price just for the down payment, not include closing costs. Many will also require 6 months to a year of reserves for Insurance, Property Taxes and some level of Capital Expenditures. Even the best SBA loan will be a 90% LTV so you’ll need a source for the 10% down payment. Many of the Self Storage investors I know have come from the Single Family home rental market and they cash out the equity of some of their rental properties to re-invest in Self Storage. Others simply tap their savings or family members. My son-in-law took an existing qualified 401k from a previous employer and created a self-directed IRA which allows you to take that tax-deferred money and invest it in pretty much any business venture you choose without penalty. This has become an extremely popular way of investing in real estate and is worth exploring that option if you have a 401k/IRA. Remember, it can’t be a plan with your current employer. It must be a qualified plan from a previous employer. Another common way of securing the down payment is by providing equity in the deal to private investors. This is called a “syndication” where you, as the sponsor, will take a piece of the deal for bringing it all together and you sell shares(or units) of an acquisition company to raise the capital required. For example, you put a property under contract for $500k and you want to use debt to acquire it but don’t have the down payment so you decide to raise the down payment of, let’s say, $200k, from private investors. You take 30% of the equity in the acquisition company for sponsoring the deal and the investors get 70% of the project for $200k. You then borrow $300k using the $200k for a down payment, making it a combination of debt and equity to secure the property. You are now into a $500k facility with zero cash out of pocket and 30% ownership.
As I mentioned, there are a lot of options for obtaining financing for Self Storage properties. They each have their pro’s and con’s and you’ll need to decide what is important to you before you get started. For example, do you require a “non-recourse” loan, meaning a loan that can’t come back on you personally if it defaults? If so, then your options will be limited on where to go for those loans. Do you want an Interest Free Bridge Loan that will save cash while you stabilize the property? If so, these short-term loans won’t be available with most traditional lenders and you’ll need to find a more specialized source. Having set that stage, I’ll outline a few of the more popular places to go for the debt you require.
If you have good credit, don’t need a non-recourse loan and are just looking for a traditional commercial loan then a community bank located near the facility is probably a great place to start. Your loan underwriting will be heavily weighted to your personal financial position, and will look something like an 80% LTV with a 25 year amorarized loan and a 5 or 10 year ballon payment. The interest rate will be competitive, probably in the 3.5-4% range right now. Closing costs will be as low as anywhere. If this sounds like a good option, give a call to a community bank or two near your location and ask them how their appetite is for Self-Storage. All financial institutions manage “risk weighted portfolio”s, which means they only have so much money to lend in certain segments so they can spread their risks. Just ask the banker and they’ll give you a good idea on whether it’s worth pursing funding with them. If they want the loan and you have a strong personal financial position then this is your best choice.
Self-Storage is a unique class when it comes to SBA loans. The SBA views it as a business, much like a coffee shop. They normally won’t lend on commercial real estate unless it’s owner occupied, but they’ll jump on a Self-Storage deal. So if you want to finance an apartment building, you need to look somewhere else. As a refresher, when you apply for an SBA loan you don’t actually apply to the SBA. They don’t lend money. They partner with private lenders to guarantee loans the lender makes via the SBA underwriting guidelines. It’s worth mentioning that not all SBA approved lenders are created equally. There are a handful that are classified as SBA Preferred and they can move quicker on your loan because they are authorized to make most lending decisions without approval from the SBA. As I mentioned earlier, SBA loans can go all the way to a 90% LTV meaning you’ll only need a 10% down payment. I’m not your dad, but I’m going to caution anyone looking to invest in Real Estate against stacking so much debt onto your project. Things happen, events change, markets move and remember, an SBA loan is a full recourse loan which means you are personally on the hook if you default. I don’t think I could sleep at night knowing I had financed 90% of my business, but that’s an individual hang up of mine. Just because you can, doesn’t mean you should. The SBA will also strongly consider the financial worthiness of the borrower (credit, balance sheet, etc) and the process can be slow but I love the SBA and the partnership they’ve created with the banking industry to get money into the hands of Small Businesses in the U.S. It’s a wonderful source for capital.
Normally when I talk to people about alternative lenders, they have visions of mobsters that will send someone after you to break your knee caps if you don’t make your payment on that 40% loan! However, the truth couldn’t be further away. These alternative lenders are normally backed by large insurance companies or Wall Street funds. They aren’t FDIC lenders but they act like it. Because they aren’t governed the same was as a traditional bank, they can be more flexible and agile. Most of these lenders focus more on the cash that a facility will generate and less on the financial history of the buyer. Don’t get me wrong. If you bring a strong producing property to the table but you’ve gone bankrupt twice in the past 4 years you probably won’t get money. But if you’re sitting with a 600 FICO and a marginal balance sheet there is a good chance to get your deal financed if it’s producing strong cash flows. This lending source is also where you go for non-recourse loans, interest only loans, CMBS loans, etc.. and most are carrying very close to the same terms as a traditional bank. Interest rates will be competitive and the flexibility / speed in which they can operate is pretty astounding. Their closing costs can be higher than a transitional bank, but it’s all about what you need and how fast you need it.
PRIVATE INVESTORS – EQUITY VS DEBT
This is a very popular way to finance Self Storage properties because investors are hungry for safe ways to create passive income with better than average returns. I’ve talked about this several times along this journey because it’s a great way to build a CRE portfolio, both as a sponsor and a passive investor. The benefit of financing with equity versus debt includes the obvious advantage of not being strapped by a mortgage. You simply pay the investors their share of distributions based on the profit of the property. If you make a decision as an investor group to take some of the profits and invest in building more units or adding RV storage then you simply pay smaller distributions that quarter. What I like to do is reserve a portion of profit for future Taxes, Maintenance and Capital Improvements. I make these reserves prior to calculating distribution payments. The cash is still in the bank but this allows us to keep distributions as consistent as possible even when we get hit with unexpected expenses. The downside to using equity versus debt is that you have to share the gains in value with investors. If you take your $500k property and drive the NOI to a market value of $900k, you’ll split that $400k gain with the investors. If you had used debt, the entire $400k is yours. It’s like most things in life — there are trade offs in the decisions we make.
I plan to acquire a couple of additional properties this year, and I will do it with equity partners. If you have an interest in participating let me know and we can talk about how it all works in detail.
The last financing option I’ll touch on is owner financing. Depending on what the seller is trying to accomplish, this can actually be a huge win / win opportunity for both parties. I’m currently speaking with an owner (they don’t know if they are a seller “yet”), and this is something that I’m going to pitch to them. Why would a seller want to finance the property themselves? I’ll list a few of the reasons here;
- Receiving a big cash payout at this point in their lives would probably be a huge negative for them due to capital gains taxes. That’s the biggest reason why retirees will shy away from cash offers. They aren’t looking for a 1031 exchange and they don’t want to pay ⅓ of their gains in taxes. All they want is consistency in their retirement income, with very little risk. By financing the deal themselves, they avoid that dreaded capital gains event.
- By seller financing, they can get top dollar for their property and not pay 6-9% of the sales price to a broker. That’s a really big incentive. A title company will guide you through the process without a broker, and the seller can pocket that savings.
- The seller continues to receive secured monthly payments, but without doing any of the work. Now they can travel, go see their grandkids, and all the other things they want to do in retirement but can’t because they have to manage their self storage facility.
- They’ll receive better than market returns on their money. I’ll happily pay a seller 6% interest on their note rather than pay a bank 3.5-4%. Why? Because I avoid closing costs and all the other mandates that a lender might place on you (such as reserves for taxes, insurance, etc).
- They maintain a first position lien on the property. The second you don’t make payments, the property reverts back to them and they keep whatever you’ve already paid to them. It’s extremely low risk for them.
Here’s an example to explain why this is good for a seller. Assume your seller has an NOI of $72k, which would put the market value of the property at $800k with a 9 CAP. That means they have a monthly cash flow of about $6k. Remember – this $6k comes with risk such as rising costs ( taxes, capital improvements, utilities, etc..). Now, assume they agree to sell to you for the market price with a 20% down payment. They will receive a check for $160k on day 1. (If you don’t have the 160k for the down payment, see the info about syndication above). You agree to a 6% loan with a 10 yr balloon. They now receive monthly checks for about $4k and a guaranteed payment of around $550k in 10 yrs. Now, all they need to do is go to the mailbox once a month for their money which is a lot better retirement than a risk filled income that needs you to be involved with the business every day.
Al this assumes that there is no current lien payment being made by the seller. If they have a mortgage, that will need to be paid off as part of the deal, so when you are speaking with the owners you need to ask how much they own on the property.
I hope that you can see that you or anyone else really can become an investor in Commercial Real Estate. It’s not about the money — it’s about desire, drive and hustle.
I’m actually writing this on a flight from Denver to Dallas to visit family and friends. As I mentioned in the opening of this chapter, I’m driving up to OKC mid-week to spend a couple of days at my acquisition site since it’s only 3.5 hrs from Dallas. With a target closing of 3/19, it’s getting very real. Our acquisition LLC is fully funded and ready to send the wire once I’m satisfied. Remember – It’s never over until the title company says you’re closed and that won’t happen until I send the wire. I love this particular small group of investors I’m working with on this deal because they fully trust me to make the go/no go decision and wouldn’t blink an eye if I pulled the deal at the last minute. Do business with people you trust and with people you like! It makes life more fun! Until next time….Scott