By Tom Dao, Principal, Gantry
This is a challenging market cycle for commercial real estate, but that doesn’t mean there are not bright spots that continue to shine for investors. In that context, self storage continues to enjoy access to the full spectrum of debt sources even where challenges exist. That is saying something. While higher rates impact proformas and access to debt across the major asset classes, as a commercial mortgage banker with a depth of expertise in self storage, I continue to look for the signs of a weakening debt market for self storage but have yet to see a meaningful change to the liquidity available to this asset class.
There have been few asset classes that have weathered the storm of volatility better during the past year than self storage for all the strength of its fundamentals. Diversified cash flow, turnkey management, relative discipline, controllable expenses, continued demand in most submarkets and not too much capacity that it can’t be absorbed. Even where rents have cooled from the red-hot pace of recent years, occupancy remains mostly healthy and operative stability continues.
Where there is softening, mainly in the Plains states, it is outside of the major primary markets, and often in the tertiary markets of these regions. For the coastal states and the fast-growing regions of the Sunbelt, assets continue to perform and absorb. We have not seen a dramatic overbuilt in primary coastal markets, as high barriers to entry and a lack of developable sites continues to restrain new construction. That’s key to health and stability. This bodes well for owners and operators with debt and financing needs in the year ahead.
New Development/Value Add:
There will be a continued cooling on new development reflecting the higher cost of capital, construction costs, and lack of viable land sites in desired markets as existing product continues to absorb towards full stabilization. But for high barrier to entry markets in major urban centers or nearby secondary markets where demand from downsizing and high-density living are creating a continued demand for self storage, capital is available from a range of sources, including life companies, debt funds, credit unions and banks, although banks are slowly returning to the market after a rough 2023.
New Opportunities: Boat and RV Storage
One of the emerging opportunities we are seeing in self storage currently is development of boat and RV storage facilities, mainly in secondary and tertiary markets as the model does not make sense in primary markets where land costs are priced to other more relevant uses like traditional enclosed storage, multifamily, or industrial. These are a byproduct from the success of self storage and relatively uncomplicated builds once entitled. Essentially covered parking lots for these oversized recreational toys, these assets capitalize on diversified revenue streams including alternative energy generation. Most cities will not allow owners to park these oversized toys on the street which is creating the demand for rental slips. The addition of a solar component generates cash flow and makes the overall investment viable. Lenders are warming up to these assets.
Right Sizing DSCR
For projects where the original cash flow projection is not being met in an over leveraged situation, there are readily accessible financing products to help right size struggling projects. Even for un-stabilized projects, preferred equity, mezzanine loans and bridge options exist in self storage you would not see for office, retail or hospitality assets facing similar challenges. For most debt investors, this strategy goes up the risk stack and offers higher yield with manageable risk underwriting. Mezzanine loans and preferred equity are higher up in stack for an asset class these lenders trust, making these allocations appealing.
Rates & Terms
Terms are paired with a solution set. Construction takeout financing is for when a project is near stabilized or already stabilized, with most borrowers looking at five, seven, and 10-year debt with flexible prepayment. For conservative loan underwriting, they should expect pricing at around a 160 to 180 basis point spread over the relative US Treasury index. Five-year debt is the preferred term target for most borrowers wanting refinance flexibility. They are cognizant of today’s high-rate climate and expect a better market down the road. Since October 2023 we have already seen the index come down almost a full 100bps with a less inverted yield curve.
Debt Capital Sources
Most of my clients are asking where the money is coming from for self storage financing. Unlike most other assets, the full spectrum of lenders is available for the asset class, with each source offering a different solution for projects in various points in their cycle. From stabilizing new construction to refinancing performing assets or developing new ones, there is capital in 2024 to meet every need.
· Life Companies – Remain as the most consistent and reliable capital source in 2024. After more than a decade actively underwriting loans to the asset class, they love it and understand it. They have accepted self storage as a preferred CRE asset class for their allocations and have bandwidth for new loans. They look for the best of the best, and while their leverage targets are more conservative than say CMBS or debt fund loans, they provide certainty of close at attractive rates.
· Banks – Long a staple capital source in self storage, banks are slowly coming back to the market. They will have requirements for deposit accounts, and they want these relationships. They will be selective and will be looking for borrowers that they can sell other bank services to. At a minimum, they will want a borrower’s asset operating account.
· CMBS – Before self storage became the attractive asset in the lending space, conduit lending was long considered the de facto capital source for permanent debt in self storage. After a hiatus in recent years as competitive capital sources emerged in the historically low-rate climate, CMBS is finally making a comeback as spreads have tightened and offering interest only payment structures that improve borrower’s cash flow. CMBS lenders are even offering a five-year term product, so conduit loans are no longer just a ten-year product. Because they can go to a higher leverage point, this makes them a competitive refinance opportunity.
· Debt funds – Who they are and why they lend can run the gamut. That being said, these lenders are definitely into self storage. Their yield requirements tend to be higher, attracting them to bridge and preferred equity yield. They are viable for construction and existing asset conversions or those acquiring at higher leverage. Even debt funds will need to see a viable exit strategy however, with loan structures that conventional lenders would shy away from.