Before you can make money with a self-storage facility, you first have to buy one. But what if you’re short on the necessary down payment cash? In this Self-Storage University podcast we’re going to review creative methods to fund your down payment capital, and how each of them works.
Episode 71: Creative Down Payments Transcript
There's an old adage that you have to have money to make money, and that's true with self storage as well. This is Frank Rolfe with The Self Storage University Podcast. We're gonna be talking about getting the cash for a down payment and some creative ideas to do that. So if you are looking at buying a self storage facility and you're lacking the amount of money you need for the down payment, what are the options? And what are some creative options that you can take the power of and harness?
Well, the first is seller financing. This has always been one of the best plans when you're trying to get into the business, you don't have a lot of capital, is to let the seller be your bank. Now, why would a seller do that? Why would a seller not say, "No, I wanna get paid cash at closing." Well, there's a couple of reasons. Number one, sellers know typically on a property that needs a lot of work, that a bank may have a lot of push back on the condition of the property or their financials, and therefore it may be hard to get a loan. So some sellers just say, "Well, I'll carry the financing because that way it's easy, it's clean." They don't get disrespected by the bank who says you had lousy bookkeeping or a property condition. So that's one reason. The other one is, they tend to make more money if they carry. Until recently, interest rates were very, very low, about 0.25% on the CD, so it made sense for sellers to carry paper because they couldn't make any money any other which way.
But even today with treasury bills and the long one still at around 3%, they can make close to twice that if they'll simply carry the paper. So when sellers carry financing is typically, it's a profit deal, they're carrying it because they'd like to make extra money from the sale. What are they gonna do with it otherwise? Well, they're gonna put it in stocks or bonds, we all know the stock market is doing terrible, bond market is doing terrible, or they could put it in CDs or treasury, something safe like that, that's fine and dandy, but you can pay significantly more than those people can. So as a result, it's not a hard sell to get sellers often to carry the finance, if they carry the financing, the key item is, now the down payment is completely at their prerogative, they can go with any percent they want, they're not like a bank. They don't get judged like a bank, they don't get inspected by the banking commission, so if they wanna go 5% down or 10% down or even 0% down, it's allowable, there's no banking regulations on that, we've done 12%, 0% down real estate deals so far, and you know, there's nothing unusual. We've also done 2.5% downs, 5% downs, 10% downs. So seller financing is always a really good one.
Now there's a derivation of seller financing when it comes to down payments, and that's cases where the seller goes ahead and demands that you buy the deal with cash, but then they will loan you the down payment money in the second mortgage. So here's how that would be constructed. Let's say you bought a self storage facility for $1 million and it was 20% down at the bank, so the bank will give a loan of $800,000, but you don't have the $200,000 for the down payment, you've got S50,000, so the seller could then... They could loan you that $150,000 that you're short themselves from closing. And now everyone's happy. They got the deal closed, they got $800,000 in cash, they also got their full price, but they only got $50,000 from you.
So the way it works is they got $800,000 in cash, $150,000 in a second note and $50,000 in cash from you. So once again, what the seller has done is they have been the catalyst to getting it done, the difference now is they got a whole bunch of cash on the front end, but the trade-off is they ended up with the second lien note as opposed to a first lien note, so if they do the direct seller finance for the whole transaction, they give with the first lien which means if you default they get the property back. Now, if you default on that second, they don't get the property back, they have a second position, which is subordinate to the bank's first position, so that's a real trade-off on that.
Another item is doing a wrap note, that's where the seller has an existing mortgage, so in this case, you're not having the seller create the mortgage, you're not going out and getting a bank loan to buy it. What you're doing is you're taking the existing first lien from the bank, and then the seller is wrapping that with a second lien position for the difference in what you pay for the property. A similar construction to the other two, only in this case, what's going on is you're keeping the existing bank that in position. Now be careful in wrap notes, there's two ways you can do them, you can do them the honest, truthful, correct way, where you tell the bank what you're doing, or you can do the kind where you don't tell the bank because you know if you tell the bank that would trigger them potentially calling the note. Now the danger on that is, what if they do call the note, what if they find out from somebody else that it was sold, which meant you had to do on-sale provision and therefore you should have gotten or they should have gotten their money back, but now you kinda cheated them, you didn't tell them that?
Now it won't come back on you necessarily as the buyer because the seller is the one who entered into the loan documents, but if they called the loan due, how in the world are you gonna pay it off? There in lies the problem. It's much safer if you're gonna do a wrap mortgage of some type, that just make sure that you look at the loan documents and it does not cause a default on the loan if in fact they sell. Another way is to do a master lease with option. So in this construction, what you're gonna do is you're going to go ahead and do a master lease of that storage facility while you take efforts to make it better, to make it more valuable, and then at the end of those efforts, you have the option to buy it in a predetermined price. What's the problem with a master lease with option? Well, there's some complications to it, number one is figuring out how the monthly amount would be because you give someone a monthly master lease payment, until you exercise the options you have to calculate that, they're certainly gonna want as much as they're currently making.
Number two, you're to come up with what the option price is, and it's typically a price that's higher than what it's gonna be right now because you're taking efforts to make it better, that's another issue. You have to figure how long the relationship lasts, is it a three-year with option or five-year with option, or two-year with option? You also have to look very carefully what you're going to do to make this deal work, how you're gonna make it better, the main thing you can do, of course, is to increase occupancy, that would be the key driver, that and increased the monthly rental rate, but master lease with options we've done many times, we've done many of them, it's not a bad construction, it typically only really works well in cases where the seller is kind of desperate because it's a very abnormal way to sell a property, because they have to trust you enough to let you take over, and they typically won't have that level of trust unless you're starting to get really, really desperate.
The last one is something to get a capital partner, there's many, many people in the self storage industry that the way they got their capital to buy that first property or that second or their 32nd is they had a capital partner. The capital partner provided the cash and then they were the operating partner and they provided the operations. Now, when you're looking at doing a capital partner, typically the structure is a preferred rate of return and a profit split. So what does that mean exactly? Well, it means... Let's just model this. Let's assume, going back to the earlier example of buying a self storage facility for $1 million, I need $200,000 for the down payment, let's assume you got no money at all. You go to friends and family or whoever you think might have the $200,000 that they'd wanna spend, maybe it comes out of a self-directed IRA, whatever the case may be, and you would say to them, "Here's the deal, I will give you 10% preferred return on your money, and then once I get you all the preferred return back and all your capital back then let's split the profits 50-50."
So how does that work then? Well, what it means is each year for their $200,000, you would owe them $20,000, and typically the preferreds are cumulative, which means that they never go away. So if you paid someone $15,000 in year one, you would have to carry over $5,000 to the next year. And what it would mean then is at the end of the movie, typically, normally not while you're still owning these deals, normally hit profit waterfalls upon successful sale, then what would happen is, let's assume it ends up selling for $1.5 million, and your current on your preferred returns, then you have $500,000 of profit, which you would then split 50-50, $250,000 to the capital partner, $250,000 to you. Now to the capital partner it's a great deal because they got a 10% return, and in this case, they got more than the money they put in at the end. So that was very successful. It's more successful for you perhaps on the rate of return because you had no capital into it, so as a result your overall return would be infinite.
The bottom line to it is if you don't have a lot of capital and you still wanna get in the storage business, you can do that. There are many creative ways people have used over the decades since the industry was started to get the job done. You just have to look at the list and say, "Okay, which one of these fits my situation and this property?", and get creative about it. In some ways, you may be able to utilize a little bit of each, you might be able to go ahead and get a capital partner in there, and yet still have the seller carry part of the down. There's no laws on any of this, this is all free country, this is all just pioneers, you're kind of just doing it whatever you agree to and the seller agree to. That's all good. I'm unaware of any laws regarding the structure of buying self storage facilities, but the bottom line is, as always, it has to be a win-win. It has to be sensible. You have to think of your worst case, your best case, your realistic case, make sure you fully understand it, but if you really think that property is gonna work for you and you're really confident in it, then you have every reason to think creatively as far as coming up with that down payment. This is Frank Rolfe, The Self Storage University Podcast. Hope you enjoyed this. Talk to you again soon.