Self Storage University Podcast: Episode 49

The Dangers Of Non-Traditional Financing

When buying a self-storage facility all financing is good financing, right? Not always. There are some unusual risks in non-traditional debt. In this Self-Storage University podcast we’re going to review the different types of non-traditional debt and what’s good and bad about them, as well as methods to mitigate the risk.

Episode 49: The Dangers Of Non-Traditional Financing Transcript

Traditional debt is often considered to be regular bank debt, but what happens when you can't get bank debt? This is Frank Rolfe the Self Storage University Podcast. We're gonna talk about non-bank debt, also known as non-traditional debt. Now, there's basically three types of non-traditional debt that happen frequently with self-storage properties. The first, seller financing, the second, hard money financing, and the third, CMBS conduit financing. And why these things are truly non-traditional is they're not governed by regular banking laws and rules. So it's kind of like the difference between a Marquess of Queensberry boxing rules versus regular street fighting. One has all kinds of codes of conduct, and the other does not. As a result, you have to be aware of what might happen to you with non-traditional banking types, both good and bad, and then how you might be able to mitigate their biggest risk. Let's start off with seller financing. Seller financing is wonderful financing for many self-storage property owners.

Number one, it does allow for low down payments, because again, there's no banking rules. Banks traditionally want 20% to 30% down, mom and pop's, when they're the banker, they don't always require that. We've done no less than 12 zero down deals in our career, but we've done many others with areas and numbers as low as 2.5%, 5%, 10%, these are all things that banks would typically never do, and that's good. Also, seller debt often has a very low interest rate.

Why? Because Mom and Pop aren't trying to make a spread between the interest rate on the borrowings and the interest rate on the capital like a regular bank, because this is just all their money. So if they're thinking, "Well, I was gonna be only getting 2% in a CD," well, then they might be able to finance you for three or three and a half, whereas it might cost you five or five and a half at a regular bank. So again, the fact that they're not structured and don't follow banking regulations, that's not a bad thing when it comes to interest rates. Also they're typically non-recourse. What does that mean? It means if you ever should fail with your self-storage property, if it ever should become non-performing and be sold at auction, they can't come after you for any deficiency on the loan. You walk completely free and all you would lose is your down payment.

Finally, mom and pop's can often give you longer terms as far as term of the loan than a bank can do. Many of your banks wanted to go with five-year terms, and many sellers may go as long as 10, some of you even gotten longer. So those are all good aspects of not following banking regulations, so what's the bad aspect then of seller financing? 

Well, the worst thing that could happen with seller financing is when the term is just too short. Now most banks will not do a loan with the goal of a term of only a year or two, but sometimes sellers will propose that. And the problem is as a borrower you can't live your life having terms that short. We normally say, "You should try and go out there and get a replacement loan one to two years ahead." Well, if you only have a one or two year loan, what does that mean? You close and the day after closing, you start trying to find a new lender? That's not really gonna work for you, you have to turn that property around and you have to seize on that for a while to even get new debt. So how do you fix that? What can you do to fix that one issue of short loan term? Well, one thing we've done in the past is to put into your agreement, in your loan agreement, the ability to buy an option.

That means typically, when the load is approaching its conclusion and it's balloon, you have a provision that allows you to pay some additional money down on the loan to extend it for some additional period of time. Maybe you can extend for two years, maybe you can extend for three years. Well, that two or three year extension might turn that two or three year seller note into something that more approaches regular bank financing, which is often five years. Let's move on to hard money lending. Now, what's good about hard money lending? The only good thing about it really is the simple fact that they all will do loans when banks won't, so if the property has significant turn around problems or maybe you're just not really that bankable, well, hard money lenders will step into the mix and they will do the unthinkable that banks would never touch. That's kind of about the only good thing about it though.

The bad items include very high interest rates, insanely high interest rates in some cases. And the biggest issue is what we call a loan-to-own mentality. Now, what does that mean? Well, banks, they don't want you to default. The worst thing a bank officer can have happen with a loan is to have it go into non-performing status. It's embarrassing, they're not supposed to allow loans to be written in the bank that can default. So banks don't want you to default, in fact, I work very hard for you not to default. If you're having trouble making the payments, they'll often go to you and try and work out a deal to maybe lower the payment and extend the term, because they do not want you to default.

If you ever have a major issue like a weather event, they'll often work with you in every which way, even events where you need more money to bring the property back to life, 'cause they don't want it to be in their list of properties that are not making payments. Hard money lenders on the other hand often have a different approach, they actually want you to default. Their best case scenario, in their opinion, it would be to take the property back and then to own it or resell it themselves, that way they get the property, let's say, a 80% or 70% loan on the dollar, and then taking it is actually the most profitable thing they can do. It's the exact reverse of what banks like to do. So how do you mitigate that? Well, you have to be very, very careful.

You have to make sure that you never will be in the position to violate loan terms. If you know that their whole goal is loan-to-own, they want you to default, they want to take it away, then the worst thing you could do is to give them that option. So if you're gonna use hard money lending, just make sure you can meet all the terms, understand what triggers the default, and then make sure with that property you are not going to get there. If there's certain covenants of occupancy, certain covenants on the percentage of coverage ratio of the mortgage payment, you have to make sure you will never run a foul of those, so make absolutely crystal clear what triggers a default. And then on the front end, when doing your budgeting and your planning, make sure you will not fall on to that category. The final type of non-traditional debt is what is called CMBS, Commercial Mortgage Back Security, or conduit debt. It's a strange animal, it's often put together by a bank, but not always. But that is sold on Wall Street where it really no longer is technically a bank loan. Now, what is good about that kind of debt? Well, it always has a very, very low loan interest rate, which is great, and typically it's a 10-year fixed term.

Well, 10 years is great. So everyone loves a 10-year term. It's also non-recourse debt, so again, that's very good, it's non-recourse debt. And another interesting thing about CMBS conduit debt is since it's not actually a bank loan like the others, it can't be called... So if the bank fails, they can't just call your loan. What are the bad attributes of a conduit loan? Well, the bad attribute ties back to the term of the loan. So if the loans are 10 years with CMBS debt, the problem is if you wanna pre-pay that loan, they have no mechanism to do it. They can't re-loan the money 'cause they're not a bank, so they'll make you go out and buy enough treasuries to cover all of the note payments till all the end, and then the balloon. That penalty is called defeasance. And defeasance on a loan can easily run 20% or 30% of the face value of the loan. So how do you get around that? Well, you can't. They don't really have any negotiability on defeasance, and if you go to a website like, you can see how gargantuan those penalties, those fees can be.

So what it really means is you cannot pre-pay that loan, at least not until maybe year seven or eight. When the loans are drafted, they don't charge you much penalty in the final year, because at that point they wanna make sure you replace the loan. They don't want you to come to the end and not have a replacement loan. So they don't really want to stop you in the final year. And then if you look at defeasance, maybe even in the year prior to that, it's not that brutal. So the long and the short of it is, don't use that non-traditional loan product, unless you're gonna hold that self-storage facility to at least probably you're seven through 10. It's not something you would ever wanna use as a loan product for something that you're going to buy and then try and enhance and then sell. The problem would be your defeasance might wipe out all your profitability.

The big thing to remember with non-traditional debt is sometimes you just have to take what you can get. Some non-traditional debt is superior to bank debt in many aspects, others not quite so good. But the key is without that debt, you can't buy that storage property anyway, so sometimes you just have to go with what you can get and then try and mitigate that rat risk as well as you possibly can. It's more important to actually physically take possession of a really good deal than to let it pass you by, and often you'll just have to work around those lesser loan terms as best you can to make it the best deal it can be. This is Frank Rolfe of the Self Storage University Podcast. I hope you enjoyed this. And we'll talk to you again soon.