MHN Asks: Can Self Storage Borrowers Make a Deal?
A conversation with Gantry's Andy Bratt on the financing outlook for the sector.
Self storage origination volume was 36 percent lower in the second quarter of 2023 compared to the first quarter, according to Yardi Matrix data. The turbulence in the financial markets was also reflected in the dramatic change in debt sources. Banks provided 92 percent of all mortgages in the first quarter. In second quarter, banks held merely 37 percent of them, followed by CMBS loans (36 percent), life insurance company mortgages (11 percent), among others.
To shed light on the fluctuating financing market for self storage, Multi-Housing News turned to Andy Bratt, principal at Gantry and a leader of the firm’s self storage practice team. “Yes, there will be pain for some in the coming months,” Bratt observed. “But real estate markets remain relatively healthy across most asset classes and major markets.”
How has Gantry’s commercial mortgage production fluctuated since the Fed started raising rates to tame inflation?
Bratt: Like the entirety of the commercial mortgage banking sector, we have seen a significant disruption to new originations from rate volatility beginning in the second half of 2022. Last year was ultimately a banner year for new production, but increasing rates really impacted 2023 from the start, across all asset classes. We’ve seen a contraction in new acquisitions as higher debt costs have presented challenges to meet lender debt service coverage requirements, buyers demanding higher cap rates to compensate for higher costs of capital and requiring a gut check for sellers on price discovery. That being said, we’ve seen an increase of activity in the last several weeks due to forced sales, the bid/ask gap narrowing, and buyers started to put their money to work.
Even though it’s not at the same pace as the last couple of years, Gantry is still actively closing loans, including new acquisitions, refinancing a crop of maturities from loans placed in 2013, 2016 and 2018, bridge to bridge loans, and our production teams continue to work on select construction loan requests and takeout financing, as most banks have contracted significantly. We expect overall production this year to be on par with years prior to 2021, which were previously banner years for new originations. Yes, there will be pain for some in the coming months, but real estate markets remain relatively healthy across most asset classes and major markets That is besides office, where challenges go well beyond capital costs and is covered widespread in the media. Gantry is still seeing 100 percent performance from our $18 billion loan servicing portfolio, which includes a healthy number of self storage loans.
How are the tight lending conditions shaping the self storage landscape? What are some unexpected challenges you need to overcome?
Bratt: For starters, the rising cost of capital has really slowed acquisitions for both stabilized and value add self storage assets alike. Negative leverage has been the primary obstacle to acquisitions, but tighter credit conditions from a retreating banking sector is a challenge for developers sourcing construction debt as well. In addition to a much higher cost of capital for development deals, construction costs have drastically increased and timelines to break ground on projects have extended, all the while construction loans are typically floating rate over SOFR, which has been continuously increasing as the Fed moves rates up. There are balance sheet and some fixed-rate options out there, but the bulk of the market offers floating-rate loan products. Since SOFR is over 5 percent before a spread is added, you are now seeing rates in the higher single digits, sometimes approaching or exceeding double digits. This means you must build for a much higher return on costs to have deals pencil or be willing to take on some negative leverage upfront, with the hopes of sourcing permanent debt later at a lower interest rate.
The combination between the higher cost of capital and impacts from higher floating rates combined with the retraction of the banking sector has really made it challenging for deals to pencil. However, there is still a robust pipeline of entitled development projects out in the market. These might be legacy deals that a developer has been working on for, let’s say, two to three years, and they are now ready to put a shovel in the ground. Self storage differs from multifamily and industrial historically, as those asset classes build to a much lower return on cost. Self storage yields a higher return on cost and has the ability to absorb some of the higher cost of capital.
What type of storage assets are lenders most willing to finance?
Bratt: So as far as what lenders are looking for, each lender’s priorities are going to be a little bit different. We see a lot of appetite for stabilized class A buildings in class A markets. There’s also a lot of appetite for value-add deals and existing properties that are in secondary or tertiary markets where the fit is maybe a smaller insurance company or more of a local bank type of program.
We are currently sourcing debt for brand new class A developments that are in lease up that we’re financing with permanent loan structures as if they are stabilized. We have class B value-add deals and we have ground up class A developments in in various parts of the country. One interesting assignment we’re currently closing is an $8 million bridge loan for a 20-story parking garage in downtown Chicago that was converted to a self storage facility. It’s currently in lease up but we’re able to fix the rate for five years with an initial interest only period on a property that is not stabilized. The majority of these assignments are expected to be sourced from insurance lenders.
The most common lenders for the storage sector were banks, CMBS lenders and life companies. Has this changed?
Bratt: The banks and CMBS have historically always been active players in the sector, but life insurance companies have really evolved into the asset class over the last decade or so. In general, we are seeing the sophistication of mortgage debt in the sector simultaneous with the sophistication of the developers and the equity on the on the ownership side. All of it is becoming more institutional as the asset class matures. I’d say that while insurance companies are still early in their time in the space, they are the most accessible sources today. Banks have obviously been in the industry longer, but they’re very hit or miss right now. CMBS remains very volatile and a heavy lift to underwrite with the least amount of borrower flexibility. While I’d say debt funds and credit unions round out the players in the space, you have put them with the banks at this time in the cycle. But debt funds have definitely become much more active over the last five to 10 years, alongside the insurance companies, growing their share of loans in the industry.
Tell us more about alternative financing options in the self storage sector.
Bratt: One alternative program that’s out in the market right now that we’re vetting with clients is a Participation Mortgage Loan. This is an insurance company program, or I would say mostly an insurance company program, where they will do construction financing up to between 80 percent to 90 percent loan-to-cost at a relatively cheap interest rate of, call it, 6 plus or minus. But because they’re doing such high leverage, they underwrite to share in the profits generated from operations on the cash flow and in the upside in the event of the sale over a three- or five-year period.
These are typically a three- to five-year loan. If they’re going to give you a cheap interest rate of 6 percent and all the way up to 90 percent leverage, they will want to share in 40 percent to 50 percent of the upside on the deal. This is a pretty attractive tool when used appropriately for developers, because they don’t necessarily have to go out and raise that 40 percent to 50 percent of their equity they otherwise might. They bring in 10 percent of the project cost and the rest is there, a loan that serves as both debt and equity.
Any advice on how to navigate the coming months? What will be the new normal in self storage financing in the near future?
Bratt: Hire a very experienced mortgage banker or loan officer in the self storage space to go out in the market with your financing request, especially on development and value add projects. If your one or two banking relationships are not active, then it’s really best to go and contact someone that has expertise in the segment. Gantry has this platform with institutional capital sources and experience to help navigate the choppiness in the market.
We are leveraging our correspondents. Looking at the insurance companies is important because of the type of creative balance sheet type of execution that they can offer. They are not just a source for long term fixed rate, low leverage debt. We’ve even created structures underwriting self storage where we can deal with lease up or value add components and structure around that, still in a permanent, fixed rate loan format. We know who has bandwidth, what their programs