Self Storage University Podcast: Episode 3

Debt And How To Get It

Financing is the lever that allows you to greatly multiply your financial returns. So what are the options in obtaining debt for a self-storage facility? In this episode we’re going to discuss the basic types of financing available today for storage properties as well as the positives and negatives for each variety as well as how to negotiate a better deal with your lender.

Episode 3: Debt And How To Get It Transcript

There's an old British saying, "Neither a lender nor a borrower be," and that's just plain stupid because when you're buying real estate, the only way you can get really high returns is by using leverage or debt. In this episode of the Self-Storage Investing Mastery podcast series, we're going to be talking all about debt, all about borrowing, the different types of borrowing that's out there, how you get it, the good things and the bad things.

Let's start off with seller financing. That is perhaps anyone in real estate's favorite form of debt. Now, you can still get it in self-storage, because you're often buying directly from moms and pops that own the properties free and clear because you see that's the first thing you have to do seller financing, is you have to have a seller that owns it free and clear. And if you own it free and clear, of course, you can convey the property however you want.

You can do it with all cash. You can do it with seller financing, with any amount you want for the amount down. So seller financing is great for a lot of reasons. Number one, when you do seller financing, you don't have to do any of the terror or anguish of going to different banks and trying to get a loan and running the risk of being turned down. That fear of rejection runs deep in any borrower in real estate, so the great news with seller financing is you're automatically approved. If they like you're approved. There's no credit check, nothing like that.

Number two, when the seller carries the paper, it gives you greater peace of mind because if they were selling you something that wasn't any good, certainly they wouldn't want to carry the paper, right? They would just want to run off with the money, never to be seen from again. Also with seller financing, you can often get a lower amount down than you can with bank financing. So, although typical real estate is 20% down, we've done 12 zero-down deals over the years and other deals that were 5%, 10%, 15%. You can't do that with bank lending, only with seller financing, so seller financing, you can get some really attractive terms.

Another advantage of seller financing is, it's all non-recourse, so if you default on that mortgage, if that property should ever go back, which hopefully it never will, but if it did and there's any loss on it to the bank, they cannot come after you personally. So that's also very important. And also speed, you can go ahead and get a seller financed loan close as soon as your due diligence period ends on your contract. You don't have to be at the mercy of the bank, trying to get through your attorney to write up documents and having delays and going on trips and things like that.

And then finally, cost. When you have seller financing, then what happens is you don't have to do some of those expensive third-party reports the banks want. You don't have to do an appraisal, for example. You don't have to do a property condition report. You don't have to do a full bore survey like you do, and there's certainly no points to pay like you do with the bank and no legal costs. So seller debt, you just can't beat it. So if you can't beat it, how do you get it?

Well, it's important to remember that we live in 2020 now, and interest rates are near historic lows. Now, I was around during the Ronald Reagan era when it was 17% interest rates. That's exceedingly high, we would all agree, but in American history, our average interest rate has always been 7%, going all the way back to 1776, but today rates are still lower. And CD and treasury rates are insanely low and very unattractive, so here's how it breaks down for mom and pop.

If you buy that storage facility for cash and they take that money and they go to AG Edwards and they say, "Hi, I want to go ahead and invest my money from the sale of my storage facility," the AG Edwards will say to them, "Okay. Now, are you a conservative investor, or are you aggressive?" They'll say, "Oh no, I'm very conservative." So they'll say, "Well, all we can offer you is about one or 2% in a CD or a treasury." However, if they carry the financing, then it's a whole nother picture. You can pay them five, even 6%, and that comes out to three to five times more per year that they're getting with that CD or treasury.

So clearly, it's financially very attractive to mom and pop, the seller to carry the financing on that. Also, look at the quality of what they're getting as far as what they're investing in. When they carry a first lien note on your self-storage facility, if you were to default, they get it back. This is something that they built. This is something that they know how to operate, so that's not altogether bad. They keep your down payment. They get their property back. What's not to like? But if they invest in anything else, if they invest and a John Deere bond and John Deere doesn't make the payments, what's that bond really worth? Well, it's not worth anything at all, so it's a crash and burn scenario. There's nearly no backup plan.

So, first lien debt for many moms and pops is more attractive than investing in intangible items of stocks and bonds and things like that. So for these many reasons, typically sellers like to carry paper, and on top of that, they like to do it often because they like you as the buyer. Bonding is a very powerful force, so if you bond with mom and pop, mom and pop therefore want to help you, and one great way to help you is to give you a loan. So seller financing, it's the best.

Now, what else is there out there? Well, if you don't get seller financing, another alternative for your storage facility is bank financing. So how does bank financing work? Well, you go to a bank, typically hopefully one near where the storage facility is, hopefully one that doesn't have a whole lot of branches, and you make application. And often those smaller banks are just like mom and pop banks. You've got one main owner or maybe a couple people and they make the decision and they do it for a lot of reasons, but of which is that they like you and they believe in the property.

We haven't done very well historically with larger banks, however, because they often just don't really understand storage and don't really want to get involved in it, but those smaller banks, those things can be real jewels. So, now, what are the terms of a bank loan versus mom and pop? Well, mom and pop's not a bank so they can do whatever they want, but typical bank lending is a 25 or 30-year amortization, interest rates right now running between five and 6%. The term of the loan, this means how long the loan runs until you have to replace it, with banks today it's normally around five years. I would say that is the average.

It's probably a window. I've seen them as short as three and as long as 10, so the amount they want down is typically 20 to 30%. So those are kind of the general terms. Now, how hard is it to get a loan on storage? Well, it's not really that hard because storage has one of the lowest default rates of any type of loan, so banks feel pretty good about making a storage loan. So typically that's not something that they have a lot of concerns about. However, at the same time they need to know the market, they need to know that you know what you're doing, and that you're buying it at the right price.

If you meet all those various items, then getting bank financing with self-storage is very, very possible. I won't say it's 100% guaranteed, but it's pretty darn close, so you shouldn't have a problem getting bank lending. Now, is there any other option? Yes. There still is one more option out there to the storage buyer for debt, and that is called conduit, also known as CMBS, which stands for Commercial Mortgage Backed Security, and yes, that's the same product that took America down in 2007, but in a different way.

That was single family home securitized CMBS debt, but it wasn't commercial mortgages, which is what this is, so basically the way conduit works is, there's an originator. It can be a bank, but doesn't have to be. They get a whole bunch of loans together, then they package them and sell them on Wall Street in these giant packages of debt. So how do you do that? How do you get in with a debt originator to get in one of those packages? Well, the answer is, you can't very well yourself at all.

You typically need to use a loan broker to do that. There's two that we prefer in the industry: MJ Vukovich at Bellwether and the other one being Security Mortgage Group. Both of these can get a roster, a plethora of potential borrowings for you, and then you choose from the list, and then they watch over it and usher the loan from beginning to end. Now, what is the problem with conduit debt?

Well, number one, it's only reserved for larger deals. You have to have a load size of at least a million dollars to possibly get a conduit loan. Number two, conduit loans can be expensive because you have to get a lot of legal fees and third-party reports involved. Number three, you can't really prepay them because they have a penalty called defeasance, which can be up to 30% of the total loan amount, so if you want to pay that loan off any earlier than the end of the note, it's pretty much impossible and you'll pay a huge financial penalty to do it.

You have to buy enough treasuries, in fact, to pay all the interest payments and principle at the end of the note in order to defease it and prepay, so that's a problem. On the good side with conduit is, those loans are always 10 years in length and they're also always non-recourse, which means if the loan should fail and sold at a loss, they can't come after you personally, so it has some other really, really good attributes to it. Amortization is typically 25 years on conduit. Down payment is typically done a little differently than a bank. 70% loan to value. They get an appraisal and they'll do 70% of appraisal.

So based on how good a shopper you are, if you bought the property for a lot lower than the average person would, you might get in with a lower amount down. You might be able to get in with 15 or 20% because it's based just on the appraisal amount only. So those are basically the three types of debts out there for storage. Is that all there is? No. Some people have bought storage using hard money debt, some have used insurance money, but those are the three most basic types that people use.

Now, what order of priority do you use those in? Well, we always shoot for seller financing because that's what we love the most. Failing seller financing, we look onto bank, and if the deal is large enough to qualify, we would definitely take conduit over bank because conduit at a 10-year length is infinitely more attractive than the bank debt is, which often isn't quite so long. Another tip to you when you're looking at borrowing money period, we think it's very important that everyone remember these highly volatileable times we have right now.

You want to get as long a note length as you can, because the way we look at it is you should start refinancing about a year ahead of when your note comes due. So that being the case, a three-year loan is only really a two-year before you have to find a way to replace it, and it's simply not long enough. Remember when you buy an asset, you're going to try and fix things, increase occupancy, maybe raise rents, cut costs. Then you have to season your number before the banks will accept that as being the truth, so let's assume you have to season them for a couple years and you need a year head start. Well, that takes you three years from where you wanted the property to be.

That's why we prefer note lengths at least five years and longer. Our primary preference is 10 year. 10 year is really good. 10 year gives you basically seven years to get the property just like you want it, two years to season it, and then a year to replace. That's good stuff. Now, sometimes with seller debt and even bank debt, you can sometimes get minor small extensions that can take you out a little bit of time because the way the economy is today, when we have the next great recession, it may make it hard to get a loan for a while, so you want to have as much flexibility as you can get.

Now, people are pegging the next recession as being in 2021. Is it true? I don't know, but if you figure that were true, you'd want your note not to come due in 2021, but at a slightly later date, giving the markets the ability to return to normalcy. But the bottom line is, you've got to have debt. Using debt is what gets you the high rates of return the people who invest in real estate appreciate, and you can never do that with all cash. So debt is not a four letter word. It is a four letter word but it's not a bad word. Don't let anyone ever convince you that it is. Sensible leverage, sensible debt is key to the storage industry and absolutely imperative if you want to make high rates of return.

This is Frank Rolfe of the Self-Storage Investing Mastery podcast series. We'll be back again soon.