Short- and Long-Term Self-Storage Financing
Interest-rate volatility has created major changes in the financial markets. In particular, rising short-term rates have impacted self-storage developers and owners seeking construction and similar loans. This article offers an overview of current financing conditions and explains the mechanics of short- and long-term structures to help you plan for construction or permanent financing.
Major changes have occurred within the financial markets in recent months, stemming from the Federal Reserve (Fed) raising the overnight lending rate by 525 basis points. In addition, there’s been talk of several more 25-basis-point hikes, plus the implosion of several regional banks that were ill-prepared for such violent rate increases.
The banking industry is crucial to facilitating economic growth and stability throughout the nation, but regional banking issues have recently emerged as a significant concern. Short-term interest rates have risen significantly, which has impacted many borrowers seeking construction, bridge or short-term lending structures.
In this article, we’ll dive into the mechanics of short- vs. long-term interest rates and how they affect self-storage developers and owners. This should help you be better informed when planning for construction and permanent financing.
The Long and Short of It
Short-term indexes such as the Secured Overnight Financing Rate (SOFR) and the Prime Rate differ in several ways compared to long-term indexes like the five- and 10-year Swap Rate or Treasury bond indices. They’re generally used for shorter-duration financial transactions, construction loans, bridge loans and variable-rate instruments.
Current economic conditions and monetary policies often influence how these indices are priced (either via federal policy and/or economic factors like inflation). As the Fed changes its monetary policy, increasing or decreasing the discount rate (the rate at which banks loan from each other), it loosens or tightens money flow and interest rates. As rates increase, the Prime and SOFR indices follow suit, and borrowers pay more interest for variable-rate products.
Longer-term indexes like Treasury yields and swap rates are influenced by broader factors, such as U.S Treasury bond supply and demand as well as economic growth and market expectations. These types of indexes provide benchmarks for fixed-rate mortgages and other financial instruments with extended repayment periods, typically five years or longer.
Short-term debt instruments are generally less than three to five years to maturity. For example, construction loans are generally 12 to 48 months. Regional banks frequently use short-term debt to address immediate funding needs like maintaining liquidity, financing day-to-day operations or managing short-term obligations. Pricing of short-term debt is entirely market-driven and, at present, considerably higher than long-term financing options due to the Yield Curve (where bond yields are cheaper than SOFR and Prime).
Short-term borrowing offers flexible prepayment options compared to long-term debt structures and can be useful for borrowers who are adding considerable value to their project via leasing and/or pre-sale. The risk does include frequent rollover costs (refinancing the debt upon maturity), which can lead to increased borrowing costs.
Short-term financing has a range of choices, each serving a specific purpose. These include interest-only loans, which involve repayment structures without periodic principal payments. Borrowers make interest payments throughout the loan term, with the principal amount due in a lump sum at maturity. Because these loans are short, borrowers need an exit strategy. This is done by refinancing with the lender who made the initial loan—securing a longer-term, nonrecourse, fixed-rate option—or selling the asset entirely.
Construction loans typically don’t include prepayment penalties, however, many bridge loans can. It’s best to consult with your financing adviser about the various options.
The problems borrowers face today are predominantly related to underwriting since short-term rates have increased so quickly in the last year. In many cases, new self-storage developments aren’t “penciling out” as they were, so the risk of building and stabilizing the asset, along with higher interest-rate payments, requires the borrower to add equity capital to make the deal work or even table the transaction until costs recede. Until we see the Fed reverse course, which will rely on wage-growth metrics, unemployment figures and inflation receding, borrowers will have to adjust their capital-stack (equity and debt) expectations.
Many borrowers looking to build self-storage facilities have had to “value engineer” their construction budget by going back to their general contractor to re-evaluate each line item, such as concrete, steel, aluminum and fixtures, since the prices of many of these have increased significantly over the past 12 to 18 months. Some have also had to defer developer fees to make a project viable.
Another problem is the lack of construction lenders in the marketplace, as many regional banks are either out of the market or are requiring a depository relationship (typically 10% or 15% of the loan amount) as an additional incentive to make the loan. Thus, finding a new lender for construction is difficult in the current environment; but if you have a well-established track record with a lender, including a depository relationship, you’ll most likely secure financing, albeit at lower loan-to-cost levels than what was available a year ago.
If you don’t have an existing bank relationship, use your capital-markets adviser to find one for you. Just keep in mind that you’ll need to establish a depository relationship with the lending source. Non-bank lenders (opportunity and debt funds) have been making construction loans, but their costs are typically much higher than your local, regional or national banks.
Long-term financing is usually for longer than 48 months. It can take many forms, such as a business loan with a five-year repayment period, a line of credit that needs to be settled within a certain period, or a mortgage that has a duration of up to 30 years. Typically, long-term permanent financing helps stabilize an asset for purchase or long-term cash-flow objectives. It’s also typically amortized, with the borrower making principal and interest payments, which lowers the balance over time.
Due to the inverted Treasury-yield curve, long-term financing is currently priced lower than short-term. However, the “spread” over the particular index (the lender’s rate of risk-return pricing) varies depending on the creditworthiness of the borrower and transaction, along with other metrics like loan-to-value, debt-service coverage and debt yield.
Currently, borrowers have access to five-, seven- or 10-year fixed-rates from 5.9% to 6.75% compared to a 12- to 18-month variable-rate or construction loan within the 7.75% to 9% range. The good news is regional banks don’t typically lend long-term since their balance sheets don’t allow them to secure these types of instruments unless they were to sell the note on the open market.
Typically, life-insurance companies, debt funds, money-center banks, commercial mortgage-backed securities (CMBS), and credit unions make up most of the long-term financing debt market, and many viable options are available. All are very active in the market today.
The Value of Working With an Adviser
Maintaining a close relationship with your real estate adviser or mortgage banker is extremely important for self-storage developers and owners, particularly now. A good professional can help you save thousands of dollars when it comes to your financing assignments, either by clearing the market for the most competitive interest rate and terms or by heeding their advice when it comes to the timing of selling or waiting for a better time to transact.
If your loan is coming due and there’s a definitive date for when it needs to be refinanced, your adviser should have the skills to find the right lending source for your project. Mortgage bankers are in the market every day. They understand what capital providers are looking for as well as their various terms, which change frequently. Most capital borrowers are in the market about once or twice per year, so hiring someone with the right expertise and built-in lending relationships is extremely important for your business plan and transaction execution.
The Road Ahead
Looking forward, it’s possible the Fed will increase short-term interest rates over the next quarter or two. Thus, if you’re in the market for a construction or bridge loan, ensure that your pro forma accounts for these anticipated hikes.
Going into 2024, the Fed will either pause for some time or start cutting rates as wage growth weakens and inflation starts to subside. I believe it’ll start cutting rates next year, which will lower the cost of your short-term borrowing or existing variable-rate loans.
With regard to permanent financing, there should be ample liquidity in the marketplace for take-out financing or refinancing self-storage assets with solid net cash flow and occupancy. As previously mentioned, life-insurance companies, banks, CMBS lenders and certain credit unions will offer attractive, long-term, nonrecourse loan terms, pending leverage, debt yield and debt-service coverage.