Many believe that self-storage facility prices are infinitely negotiable as long as the seller and buyer agree to a price. But that’s simply not true. In this Self-Storage University podcast, we’re going to discuss how the banking industry ultimately fixes values and how to embrace and follow these guidelines instead of wasting time pushing along deals that will never be able to get financed.
Episode 89: When Values Meet A Stone Wall Transcript
People think that the prices of self-storage facilities are infinitely variable. They're... Really the final price when the hammer comes down will be whatever is agreeable between both buyer and seller, but the truth is there's a third component. This is Frank Rolfe with Self Storage University Podcast. We're gonna talk about that one additional ingredient that, in fact, does make the price to some degree set in stone, and that is a little item called the bank's coverage ratio. Now, what is a coverage ratio? Well, banks are pretty clever, they've been around since the beginning of time, they did all the way back to the ancient Egyptians, the Greeks, they all had bankers. And what a banker does is they loan you money, and they get interest on that money, and the key item to the banker is they get all their money back.
There's a modern adage that before you have return on principle, you must have return of principal. So that's how bankers are, they are conservative by nature, they wanna make sure that they get their principal back, because when the bank doesn't get his principal back, it takes a loss and that loss can outstrip a whole lot of interest. Also remember the banks don't get any upside in your deal, so if your deal is a raging success, that's great and everything, but the bank doesn't get anything but their interest. And if your deal is a total dog, again, all the bank had to get out of it was the interest, and then they didn't even get that. So they aren't optimists, they're pessimists. And one way that a bank protects itself is with what's called the coverage ratio. So what does it mean?
Well, the bank's gonna wanna see on your storage facility, do you have perhaps a 1.25 coverage ratio, which means the park generates enough cash flow, enough net income to cover the mortgage, and then some at a 1.25, 125% per month of the mortgage payment capability. Now, the coverage ratio is not set in stone, that can be flexible. There are banks that do 1.2, 1.25, 1.3. That's not the key item, the key item is it all ties back to the net income. So before you can have a coverage ratio, you have to have net income, and that net income and that coverage ratio will in fact limit how much you can pay. For example, you're looking at a self-storage facility and at a 1.25 coverage ratio, the most mortgage that its net income will cover would require the price to be $2 million. Do you think you can then pay three?
Well, you could, but if you pay three, you'll have to come up with more than the lenders valuation of two, because you see, that's all the mortgage they're gonna give you. So you'll have to cut a check for a million dollars of closing to buy that property because the coverage ratio doesn't allow them to go up anymore. Now, the good news from that is that banks can be very helpful with their skeptical attitude, because it can often keep the borrower out of trouble. If you look at some of the dumbest deals ever done in real estate what they all had in common was the lenders were too loose, they lower their constraints and let the borrower get in all kinds of trouble. So you really want a bank to be tough, you want a bag to have tough love and say, "No, you can't do that. That's stupid. You're gonna sink yourself and you're gonna sink the bank too."
And that's what the coverage ratio is all about. So if you're a borrower and you come up on that piece of stone, that value, well, maybe that's about all you should be paying, plus your down payment, because that bank is not foolish. They're not willing to risk their money for no reason. Now, the buyer sometimes is, a buyer says, "Well, but you're not looking at the upside, you see, there's 20% vacancy and I can fix that. And the rents are kinda low, and I can fix that too. I can do all kinds of wonderful things." And yeah, that may be true and all, but in life, it's best to do a best case, a worst case, a realistic case scenario. And what the bank is looking at is typically somewhere around the real and the worst, because that's what their world is. They cannot afford for you to lose the property, they cannot afford the thing to go bad, but it's not a very bad beginning to start off with as your worst case.
Now, self-storage facilities like all real estate are based on leverage. Very few people, if any, buy a property for all cash, because you can't get return on real estate unless you use leverage. That's the magical tool. So if you can get a two-point spread between the interest rate and the loan and what you pay, well, that's great. That would get you a cash on cash return of somewhere around a 15 or 16%. And that's why people use real estate because you can't get that kind of leverage as a tool, for example, when you buy a business. It does not exist. Banks won't loan it to you. So leverage is great, but most borrowers, when they think of leverage, they wanna put down roughly 20 or 30%. That being the case, if you use as ratio, that means you're willing to pay somewhere between three and five times their down payment in the total property.
If you start running up against the limit of the mortgage based on coverage ratio and think you'll solve it by throwing even more cash in, instead you'll end up at leverage, it might be only 50%. Now, when you start using low leverage, yeah, that's great and everything as far as maybe your safety and the deal, the problem is you don't actually hit those returns. So except for those rare buyers who are willing to put down more than a 20 or 30% amount, then as the bank tells you, "Nope, that's all the mortgage I can do." Yet, you're so far off from what the seller wants, most buyers aren't going to do it. So really what happens is the bank is really helping you by giving you that upper limit on price. Now, you can always go lower, banks love it when you buy something for far less than it's worth.
They love it when the loan coverage ratio is even higher, but they're not going to really come off that upper guideline. And that is ultimately going to limit where you're going to be. Now, we've been doing real estate for almost 30 years now. And I've seen a lot of swings, I've seen banks, they get all excited on something and then start to lose interest over the years. And I can tell you, don't fight what the banker tells you. When the banker tells you, you know what, looking at this, this is kind of where I think the price needs to be, this is probably the upper limit. You gotta embrace that because bankers are often smarter than you are, you see, they're not looking at the upside. They're the same party in the room.
There was a guy named Clint Murchison back in Dallas back in the 1960s and 70s, and he owned the Dallas Cowboys. And that was a good asset to own, although back when he owned them sports teams weren't anywhere near as valuable as they are today. They were considered... A good one would be worth maybe 100 million bucks. And even if you inflation adjust, it's nothing like today's values. But what happened with old Clint Murchison was he was an oil, wildcatter oil driller, and then he started dabbling in real estate, 'cause it was kind of a sexy, fun thing to do to own big office buildings and things like that. And he kinda went into it with abandon, and he didn't listen to the banks and at the end of the movie, he had way, way over invested, he paid way too much.
He had it all on personal recourse debt. And when the market fell out back in the 1980s during the savings and loan crisis, he lost everything. He lost the Dallas Cowboys, he just lost all of his assets and things, because he didn't listen to the banks along the way. If he'd only listened to his banker, I'm sure the banker the whole time was saying, "Clint, don't wanna invest in that. Are you crazy? That's way to risky. You're doing great. You have the Dallas Cowboys, you have a giant house. Don't do that." But no, he had to go out there and do it. So a lot of times when you ask yourself, should I really buy the self storage facility? The key item is, what does your bank say about it? Now, some people think that the appraiser is the one who really sets the value, but the appraiser doesn't.
The appraiser is really directed by the bank. The appraiser's also really directed by cap rates and what things are like and comparable sales. So at the end of the day, who really sets values are the banks. Now, it shouldn't be that way. The appraiser should be truly independent, but you know, appraiser's, big customer of banks. And so the bank calls the appraiser and says, hey, we're looking at making a loan on the self storage facility, and we're kind of sort... We're thinking it's worth 3 million bucks. What do you think? Well, you better believe he's gonna come in at probably 3 million bucks because that's where the banks are kind of directing them. But on top of that, even if they weren't, the bank is kind of setting the market because of how much they will loan.
So when a bank is set in stone and says, nope, won't loan any more than that. Then pretty much, that's what the value is at the end of the movie. The bottom line to it is, it's probably a good thing that you do have this anchor, this solid Rock of Gibraltar sitting out there on any soft storage deal and it's called the bank. And that value is created by what's called the coverage ratio. You can't rationalize it, you can't move it, you can't yell at it. You can't try and connive it or scream at it or do it. It's not malleable. It's firm, it's solid. But that's really a good thing for all self storage buyers. This is Frank Rolfe, the Self Storage University Podcast. Hope you enjoyed this. Talk to you again soon.