Strong fundamentals. Operative performance. Institutional creditability. Sponsor sophistication. In the past 10 years, self storage has worked hard to come of age as an asset class and has proven itself to be one of the more attractive investments in commercial real estate. This status has not gone unnoticed by financing sources. In just the last five years, self storage has managed to move from an asset class of interest to a preferred asset class for many traditional lenders.
The operative model offers a very understandable cash flow and revenue source with the right operator and right location in place. While not glamorous, it has shown consistency, resilience, and relevancy. Strong performance both during and post-COVID has only cemented this status, increasing targeted loan allocations to this asset class in a meaningful way. This bodes well for borrowers in 2022.
New Definition for Self Storage
Self storage is a hybrid property class blending operative elements of industrial, multifamily, and retail. Industrial often defines construction technique and site selection characteristics. Historically, self storage has functioned as a specialized category of this asset class in theory. However, it is so much more. The average length of its rental agreements and opportunities to adjust rents to take advantage of market conditions more closely mirrors a multifamily revenue model, making cash flow potentials extremely resilient. Elements of retail round out the self storage story as a good part of asset revenues come from the sale of boxes and packing supplies, as well as insurance services, all from a fixed location. Understanding the intersection of these three operative truths has improved lender underwriting and defined self storage as a truly unique asset class unto itself.
Capital Options Emerge
Historically, options for self storage financing were mainly limited to banks and CMBS lenders. That is changing. Banks remain the primary source for funding self storage development, beginning with land acquisition and continuing through entitlement, construction and stabilization. These loans are typically recourse driven. Understand, however, that few banks compete for longer term loans on this asset class, and in this era of generationally low rates, attractive long-term permanent financing for self storage is available from other sources.
CMBS lenders have understood the self storage product type for some time. They offer long-term financing at higher leverage points and provide maximum dollars. For borrowers, CMBS requires a lot of structure and documentation during underwriting, can often be inflexible on post-closing loan event requests, and doesn’t offer rate lock at time of origination. The latter is a relevant difference in the current cycle between CMBS and life company debt. These have always been accepted tradeoffs when relying on CMBS since, in past cycles, it was often the most viable option for securing attractive long-term financing for these assets.
In recent years, more life companies have gotten into the game for long-term financing as these lenders have become more educated on the asset class. This is creating options for self storage borrowers that previously didn’t exist. There has been a lot of activity in the traditional capital markets over the past five years and, in today’s market, self storage is as attractive an allocation to many life companies as assets in the multifamily and industrial verticals.
For self storage properties there are two key thresholds to meet post construction. Stabilization and optimal market rate revenue. The first preceding the second was historically a challenge for securing long term financing at construction loan maturity. Historically, life company lenders would have been looking for trailing 12-month performance at market rates. In a typical lease up model however, sponsors are often leveraging concessions in early phases to hit a 90 percent to 95 percent occupancy, and then within the next 12 to 18 months grow rents to market rates.
In today’s lending environment, when a self storage property hits 90 to 95 percent occupancy, it is essentially considered stabilized but often not optimized. Regardless, lenders are now able to analyze and predict the difference of projected performance from lease up concessions and incentives and underwrite a long-term loan from projections. Life companies have become especially adept at placing debt that understands this dynamic, and this can lead to funding that offers 10-year stability by including hold backs for subsequent funding at finalized revenue stabilization. That allows sponsorship to move forward in a two-step funding model.
Peter Welsh is principal, Gantry.