Self-storage comes of age with traditional lenders
Solid fundamentals. Operational performance. Institutional credibility. Sponsor sophistication. Over the past 10 years, self storage has worked hard to become an asset class and has proven to be one of the most attractive investments in commercial real estate. This status has not gone unnoticed by funding sources. In the past five years alone, self storage has successfully transitioned from an asset class of interest to a preferred asset class for many traditional lenders.
The operating model offers a very understandable cash flow and revenue stream with the right operator and location in place. Although not glamorous, it has shown consistency, resilience and relevance. Strong performance during and after COVID has only cemented this status, significantly increasing targeted lending allocations to this asset class. This bodes well for borrowers in 2022.
New definition of self-storage
Self-storage is a hybrid property class blending operational elements from industry, multifamily, and retail. The industry often defines the construction technique and site selection characteristics. Historically, self storage theoretically functioned as a specialized category of this asset class. However, it is so much more. The average length of its leases and the ability to adjust rents to take advantage of market conditions more accurately reflect a multi-family revenue model, making cash flow potentials extremely resilient. Retail elements round out the self-storage story, as a good portion of the asset’s revenue comes from the sale of boxes and packaging supplies, as well as insurance services, all from a fixed location. Understanding the intersection of these three operational truths has improved lender underwriting and defined self-storage as a truly unique asset class unto itself.
Emerging capital options
Historically, self storage financing options were mostly limited to banks and CMBS lenders. It changes. Banks remain the primary source of financing for self-storage development, beginning with land acquisition and continuing through rights, construction, and stabilization. These loans usually come with recourse. Understand, however, that few banks compete for longer-term loans on this asset class, and in this era of generationally low rates, attractive long-term permanent financing for self-storage is available from other sources.
CMBS lenders have understood the self storage type of product for some time. They offer long-term financing at higher leverage points and provide maximum dollars. For borrowers, CMBS requires a lot of structure and documentation when underwriting, can often be inflexible on lending event requests after closing, and does not offer rate lock-in at origination. The latter is a relevant difference in the current cycle between CMBS debt and life insurance company debt. These trade-offs have always been accepted when relying on CMBS since, in past cycles, it was often the most viable option to secure attractive long-term funding for these assets.
In recent years, more and more life insurance companies have gotten into the game for long-term financing as these lenders have become more educated about the asset class. This creates options for self storage borrowers that did not exist before. There has been a lot of activity in the traditional capital markets over the past five years, and in today’s market self-storage is as attractive an allocation for many life insurance companies as assets in the multifamily and industrial.
For self-storage properties, there are two key thresholds that must be met after construction. Stabilization and optimal income at the market rate. The first preceding the second was historically a challenge to obtain long-term financing at the maturity of construction loans. Historically, life insurance company lenders would have sought a rolling 12-month performance at market rates. However, in a typical rental model, developers often leverage concessions in the early stages to achieve 90-95% occupancy, then, in the following 12-18 months, increase rents to market rates. .
In today’s lending environment, when a self-storage property reaches 90-95% occupancy, it is essentially considered stabilized but often not optimized. Either way, lenders are now able to analyze and predict the difference in projected performance against lease concessions and incentives and underwrite a long-term loan based on the projections. Life insurance companies have become uniquely adept at placing debt that understands this dynamic, which can lead to funding that provides 10-year stability by including holdbacks for later funding upon final stabilization of income. This allows sponsorship to move forward in a two-step funding model.
Peter Welsh is Director, Portico.