There are a lot of self-storage properties in financial trouble, and certainly more to come. The doubling of interest rates since 2022 and excessive over-building has created a market in which distress is common. In this Self-Storage University podcast we’re going to explore the correct game plan for buying distressed self-storage facilities.
Episode 155: How To Buy Distressed Deals Transcript
If you're in the self-storage industry and you think things are going well, then you're probably reading or hearing only stories from brokers or large-scale storage operators who are perpetually gaslighting that everything is just fine. There's no reason for concern because the reality is far from that fantasy. There's a lot of distress going on right now in the self-storage industry. And as a result, when you're looking for deals to buy, it's no longer only a case of buying storage properties from moms-and-pops, but now there also comes the opportunity to buy them sometimes from lenders. This is Frank Rolfe with the Self Storage University podcast. We're gonna talk about how to buy distressed deals.
Now, what causes a storage facility to go into distress? Well, clearly not paying your mortgage. That'll definitely make your loan go into default and definitely get the bank involved, that's for sure. But another thing that happens frequently is people are unable to replace their debt, and these are called term defaults. And in a term default, the property can pay the mortgage, but the loan expires. And as a result, they can't get a new loan, and so it goes back to the bank yet again. Now, there are other things that can also cause self-storage properties to go into default. They may not meet whatever covenants they have with the lender on coverage ratio or occupancy. All kinds of things could happen to make that storage facility not work. Oversupply has been rampant. Probably the two biggest things that we see right now are the rise in interest rates. That's been a big deal. Since 2022, we've seen interest rates rise faster than they have in 40 years. It's had a huge impact on interest rates, cap rates, valuations. There are storage properties out there which are worth half of what they were when people bought them. And here's what happens. If your storage property is worth half of what you paid, then when you get your loan renewal, you're not talking about the same 20 or 30% down you used when you purchased it. Now we're talking having to put down maybe 70% of what you did when you bought it. And if you can't write the check, if you don't have the capital to cover that shortfall, what happens? Well, the bank is gonna take it back.
Now, we know that lenders have been trying to work with many storage operators who are in this bind where the property is upside down, using a method called extend and pretend. And what that means is you just extend the loan out farther and you pretend it will all work out okay. But a lot of lenders have stopped doing extend and pretend for the very reason they've lost confidence. They don't believe that the borrower will be able to turn it around. And in some cases, neither does the borrower. And rather than feed a property they may lose, they simply just give up, throw in the towel, and give it back to the bank. So how do you approach a lender-owned property? Well, here are some options. Number one, you can buy it before it's even foreclosed on. You can buy the note from the bank for the storage facility, normally at a big discount, because they don't want to have to go through the effort of trying to go ahead and get the property foreclosed on. There's all kinds of legal challenges to that, legal costs.
Now, I will tell you, if you're gonna do that kind of a deal, and we've done deals like that, the key is you've gotta do what's called a deed in lieu of foreclosure. You have to get that signed during due diligence before you buy it, because you really don't want to buy a note, even at a discount, praying that somehow you will eventually get title. All they have to do is declare bankruptcy, throw it into the incredibly flawed US court system, it might just pop around in court for years. There could be appeals, all kinds of stuff. Nobody wants to put their money into that. But if you go to the borrower and say, "Hey, if you sign this deed in lieu of foreclosure, I will eliminate personal recourse," that sometimes does the trick. You see, that's the bank's mistake. The bank could do the same. The bank could say, "I'll tell you what I'll do. I'll get rid of your personal recourse on the debt if you'll go ahead and do a deed in lieu." But they won't do it morally because they don't like the idea on a recourse loan of letting the person off the hook. That's really a dumb way to do it.
Another thing you can do is you can buy a storage property at an auction. Sometimes banks take storage properties to auction, often absolute auction, because they don't want to own them after a certain date. And the fastest, most sure way to guarantee that storage property is no longer in their portfolio is to take it to an absolute auction, which means the highest bidder wins no matter what. No reserve, it's out the door. But buying at auction can be very, very difficult and scary for most people because you have to do your diligence before the auction. And if you win it, you have to put up 10% the day you won it typically, and then the other 90% within 30 days. It's really, really hard to get a loan on a property, particularly one that has failed, that quickly from the bank.
Another way you can buy distressed property is to go to the existing bank and work a deal for them to continue to be the note holder, but on different terms with you as a new borrower who can make payments. Those kind of reworking of bank loans is a great way to buy distressed properties with a lot less risk, a lot less anxiety. You already have the lending worked out. And then finally, you can often buy distressed properties from brokers. Often banks will list those properties with brokers and have the broker take them to market where they're not in an auction situation, where you can tie it up under contract and then do due diligence, and you can also get a loan and you have time to get that done. But what should you watch out for when you're looking at distressed storage properties? Well, number one, the big one: things you can't fix. You can't fix a market. You have no ability to go in and change actual market demand. You have no way that you can personally change the economic trajectory of a failing market. You also can't just change overnight extremely high vacancy because it takes a while, if you can get it fixed at all.
Also, if there's any city litigation regarding the validity of the facility or of an expansion, whatever the case may be, you can't always get that fixed. So if you're gonna buy things, make sure you know how to fix whatever is wrong or you'll be no different than that failed borrower. You'll just be the next failed borrower. Some of the key things you should look for, I would say that term default loans are absolutely the best. Because when you go out and look at a property that is in foreclosure or non-performance in term default, those properties often look just fine. Sign out front is nice, property condition is nice, occupancy's okay. It's not the problem with the property; it's with the borrower. Sometimes those loan defaults basically on the term default boil down to nothing more than the borrower got totally screwed up. I've seen cases where the borrower bought a giant McMansion and then defaulted on it and it got foreclosed on, and now they can't get any of their other real estate loans redone. Term defaults are really, really good. Also look for deals where it's not a market issue, it's a management issue. There's a lot of really bad managers in the self-storage industry, you can spot them from a mile away. Those are the things you really can fix because you'll get rid of the current management on day one and then you can go in and fix those problems.
Now, another thing you need to know about buying distressed deals is the one time where win-win deal-making typically is not the way to go. Because in these drowning rat scenarios, people are always gonna go for the bigger, better deal no matter what they morally told you. So it's really every person for themselves. We've had deals where we thought we had something forged with the lender only to find out behind our back and without any notice they went with another buyer for some small amount of additional money, 10 grand, 20 grand. Also, the most important overriding issue in buying distress, you have to trust your gut instinct. Because your gut instinct is so important on these type of deals. As an adult who's amassed the capital to buy a storage property, you know right from wrong, you know up from down, you know when things look shady and when things look right. And when you find a deal in distress, it typically means you can buy it at a discount. And if your gut instinct tells you, "Oh yeah, that's a real sweet deal," then it probably is. This is Frank Rolfe with the Self Storage University podcast. Hope you enjoyed this. Talk to you again soon.