By Hugh Kreizenbeck and Joseph Maehler

Just as someone seeks the expertise of an orthopedic surgeon in the event of a serious knee injury in order to minimize risk of re-injury or a botched surgery, a self-storage facility owner should choose his lending source wisely in order to minimize the risk involved with financing a property. Owners face important decisions when seeking acquisition or takeout financing, and unforeseen risks can significantly increase the cost of financing. Furthermore, if the loan process is not controlled and managed in detail, owners run the risk of being left with unfavorable loan terms that can reduce cash flow or make a loan more costly and difficult to pay off thus complicating future refinances or even sales. Capital market risk and underwriting risks can result in deal changes that can hinder the performance of a property. Owners also run the risk of over-leveraging a property which can put added pressure on the operating staff or even make a property unmarketable.

Capital Market Fluctuations
Fluctuations in the capital markets, like the recent upheaval spurred by rating agency and investor concerns about overly aggressive underwriting, can cause lenders to change deals in multiple ways such as rate increases or reduced loan proceeds. When a lender’s cost of capital increases, the cost is almost fully passed on to the borrower. All lenders, especially those that securitize their loans (sell loans in the secondary market), protect their profitability by reserving the right to change deal terms during the due diligence process.

Lenders disclose this right in the loan application under the “materials adverse change” clause (commonly referred to as the MAC clause). Although it takes a major capital market disaster or shift for lenders to change deal terms, a borrower can mitigate this risk by fully flushing out how the property’s cash flow is underwritten on the front end.
Therefore, a borrower should align themselves with a capital markets advisor who has significant storage experience and strong lender relationships.

Borrowers are not going to do business with an advisor when loan terms change mid-process unless there is a market-wide correction that affects everyone, and advisors are not going to do business with lenders that are known for changing loan terms. Thus, in the event of a typical capital markets shift that may cause a lender to revise terms, the lender will work extremely hard to hold deal terms constant so as not to jeopardize future business from the borrower and the advisor. Lenders will never remove this MAC clause; however, borrowers can take precautions to prevent deal changes by ensuring that their cash flow has been thoroughly underwritten by storage experts so that the loan can close quickly.

Controlled Loan Process
After a prospective borrower begins the loan process, the lender begins the due diligence process during which they verify items such as the market value of the property, underwritable cash flow, the borrower’s credit history and overall asset condition. Lenders do this via their internal underwriting process and third-party reports such as appraisals, Phase 1 environmental studies, property condition assessments (engineering reports) and zoning reports. If a third-party report comes back negative, or if unexpected issues arise, the lender has the right to change the agreed-upon loan structure. In order to mitigate third-party report risk for the borrower, the advisor can control the loan process through the following due diligence:

	Appraisals. It is very important for the lender to choose an appraiser that specializes in self-storage so they give full value to the property. Appraisers who are not familiar with self-storage often undervalue the property by not giving credit to certain ancillary income items such as merchandise sales, insurance sales, late fees and administrative income. Also, they may not have the most current sales comparables. If the property does not receive the appropriate value, then the lender will reduce the borrower’s loan proceeds.
	Phase 1. Many properties have associated environmental conditions or history that the borrower should disclose up front. If an owner has previous environmental reports, those reports should be provided to the newly hired Phase 1 vendor prior to starting their work to give them the proper direction when they review the asset. If a Phase 1 comes back “dirty,” a lender has every right to completely back out of a loan or request an escrow to be held back from the loan for as much as 125 percent of the estimated cost to remediate the environmental condition. In today’s capital markets, lenders are very sensitive to environmental risk. Thus, if a Phase 1 comes back dirty, they will more than likely choose to back out of the loan causing the borrower to lose time and money.
	Property Condition Assessment. Third-party vendors may identify items at a facility that need to be repaired immediately based on an estimate of age or appearance. Once identified, lenders will withhold up to 125 percent of this immediate repair cost which further reduces proceeds. If this occurs during acquisition financing, the borrower would have to come up with more money or show the lender why the identified item is not an immediate repair. Borrowers can easily mitigate the risk of vendors’ finding any immediate repairs by providing a list of all major capital expenditures and improvements made at the site. This list typically includes the last three years of repairs made at the property and a budget of future repairs.
	Zoning. Lenders must verify that all improvements at a storage property are properly zoned and, further, in the event of a casualty to the property, that the assets can be rebuilt. Borrowers can give zoning vendors direction by providing old ALTA surveys, certificates of occupancy, special use permits and the zoning codes up front. This gives the vendor direction as to how the property was originally approved upon development. It is highly likely that the lender will not close on a loan until a property is in full compliance with zoning laws.

When obtaining a self-storage loan, a borrower faces several risks during the due diligence process, most of which can be mitigated by engaging an industry specialist. For example, to protect a loan, a lender may reduce loan dollars by setting aside sizeable escrows that can only be released after some form of remediation, repair or performance of the property. This can sometimes cause stress to the asset and/or operations team.

Carol Shipley, President of United Storage Management, recognizes the importance of mitigating third-party risks in the early stages of financing. “In many cases, certain financing structures like earn-outs or hold-backs place added pressure on the operational side of the business. Based on the fact that managers are the front line for the facility’s performance, they truly need to make sure that the occupancy levels remain strong in order for the negotiated debt hurdles to be released,” commented Shipley.

Over-Leveraging
One risk that some borrowers fail to focus on is how much debt to put on an asset. There has been a recent flood of capital into the real estate debt markets, and, in order to compete, lenders have offered more aggressively leveraged loans. Some lenders are enhancing their collateral with liquid assets such as cash escrows or letters of credit to over-fund loans that may not qualify for the desired loan proceeds today. The additional loan funding can put borrowers at risk for over-leveraging the property to a level that the asset cannot support. This can result in a borrower’s being stuck in a situation where the additional collateral is never released, meaning the borrower would have hundreds of thousands of dollars tied up for the term of the loan if the property is never able to increase cash flow enough to reach a pre-negotiated debt hurdle.

This risk is easily mitigated in two ways. First, don’t fund proceeds based on a “best case” stabilized income level that is too aggressive. The lending source should be able to determine an exact, realistic monthly rental collection number needed in order to get the additional collateral released. Second, the risk is easily mitigated by negotiating lengthy periods within which the property has time to improve cash flow and secure the release of the additional collateral. Most lenders will limit this time frame to 24 months; however, it can be expanded to 48 months or more on a deal-by-deal basis. Furthermore, a borrower should negotiate for multiple releases though most lenders will want no more than two releases. Also, depending on the length of time an asset has to improve its cash flow, the borrower may often negotiate four chances to get a letter of credit released. It is important that the borrower negotiate these terms with the lender up front, prior to going under application.

Bryce Grefe, owner of Storage Investment Management, Inc., is an owner who understands the loan process from start to finish. Grefe states, “It is very important to realize that the market conditions are ever-changing, and you have to be knowledgeable about the process in order to maximize the benefit over the negotiated loan structure.”

In summary, a borrower can face several unforeseen risks that may result in reduced loan proceeds, increased costs and undue pressure forced on the operating staff or asset. However, a prudent self-storage owner can successfully mitigate these risks by focusing on key transactional aspects of the lending process and not just the economics of the loan being provided like the interest rate or final loan proceeds. Self-storage is a niche real estate asset class, so, just as it makes sense to seek out an orthopedic surgeon who specializes in knee injuries, a borrower should carefully select an experienced team of storage specialists to help achieve the desired financial goals.

Hugh Kreizenbeck is Vice President and Joseph Maehler is a Capital Markets Specialist at Buchanan Storage Capital. Buchanan Storage Capital is the leading provider of capital to self-storage owners nationwide. Their customers access competitive debt and equity through programs like Buchanan Fixed Rate Direct™ and through their advisory services, leveraging off Buchanan’s long-standing relationships with the top storage lenders. Parent company, Buchanan Street Partners, is a national real estate investment bank that provides real estate capital and advisory services for owners and developers, and investment management for institutional and high-net-worth investors. For additional information, please call 800-675-1902 or visit www.buchananstoragecapital.com.