We have been discussing the seven skills required to start a successful self storage business today. The information is from an article I wrote for Inside Self Storage. In this series, I’m taking a deeper dive into each of the skills mentioned in the article.
The two skills we’ve already discussed are the ability to find deals (or getting in front of deal flow) and analyzing self storage prospects.
This week we’ll cover financing.
Going in debt has a bad wrap. In many cases, however, debt is awesome. In the self storage business, it’s cheap money and someone else is okaying it for you.
Early in my career, I had a very successful man tell me, “If you are born poor and never go into debt you are going to die poor.”
Getting a Loan
Your ability to not only get a loan but get a good loan, for self storage is critical.
When you start a self storage business you are purchasing assets that will generate “operating cash” as well as appreciate in value.
How will you purchase, or in the case of building, fund the cost of creating those assets?
Let’s take a view from 40,000 feet up.
If you had enough cash yourself, you could just buy the asset (a self storage facility).
In most cases, especially today, this is not a good idea.
Why?
You won’t get a very good return on your money.
Why?
If you buy on a 6% CAP rate, for example, that means that after operating expenses the income the assets are generating is 6% of the cost of the assets.
I don’t know about you, but most small investors want a better return on their money than that. If I put the same cash in a mutual fund I could most likely get the same return. And I wouldn’t have to run the business or pay someone to run the business to generate operating cash from a self storage asset.
But what if I could buy the majority of the cash to purchase the assets at 4.5% to buy assets generating a net income of 6%.
Right there alone, I am making money simply by using money that cost me less than what the assets are creating in operating cash.
That is called leverage.
I am leveraging the bank’s money to create a higher return.
In theory, if I could purchase all of the self storage assets with 4% or 5% money from the bank, I would be increasing my return.
This is true.
However, the lower cost money used from the bank means a greater risk to you because so much of the net operating cash would have to be used to pay the cost of buying that money.
If that net cash went down for some reason, like a new facility opening up close by and you lost some occupancy, the cost of that money could be more than the assets are generating in operating cash.
Then you are “upside down”.
In today’s world bank who sell the money want you to self-fund 25% or more of the cost of the asset. This way if there is a downturn in the amount of net income the asset generates, there will still be enough to pay for the cost of their money.
As a rule of thumb, for normal banking, (we will discuss some not normal banking in a minute), they like to see what they call a 1.25% “debt coverage ratio.”
What is that?
That just means that they will calculate a payment for the cost of buying their money. The net income generated by the asset needs to be 1.25% more than the payment for their money.
For example, if it cost $100,000 per year in payments to buy the bank’s cash, they want to see a net income after operating expenses (NOI-Net Operating Income) of $125,000.
That is how the people selling you cash rate their risk of you being able to pay it back. If the NOI is 1.25% or more than the cost of buying their money, they deem it safe enough to sell you their money(they call it lending).
“What if I am building and there is no way I can have a 1.25% debt coverage ratio, at least at the start of the project?”
The banks know this, so they will rate their risk other ways such as how fast will it lease up, what will the debt coverage ratio most likely be when it does lease up, etc.
That is where a feasibility report comes in very handy.
That is also where you having your reports from the Storage World Analyzer come in handy as well. Or your excel reports, although the reports from the Analyzer look so much better (shameless plug I know).
You can show them what the numbers will look like as you lease up the asset to the point where the debt coverage ratio is met.
I know we don’t talk in the real world about buying assets to generate operating cash and buying banks money at a lower rate than the rate of return the net operating income was purchased at.
But that is what is actually going on.
If you can see what is happening at this level, you begin to see how important the financing is.
Not just getting a loan, but having the terms of the loan enhance the return you are getting from the self storage facility.
You can also begin to see why the value-add play is so important today.
If most facilities are selling on a 6% CAP rate (i.e. the NOI is generating a 6% return on the cost of the facility), and my bank financing is 4.5%, that is only a 1.5% spread between 75% of the cost of the asset.
How in the world will I get a 10%, 11% or 12% return or better?
Well, I need to create more assets at a lower cost (expansion). After I blend the cost of the original assets with the cost of the new assets (expansion), I can most likely generate the returns I need on my 25% of the cash going in.
That is another reason the analysis is so important.
Not only do you need to have faith you can generate the returns needed, but you will also have to demonstrate it to your banker as well, or they will not give you 75% of the cost at a lower than CAP rate interest rate.
If you have partners providing all or part of the 25% cash you are putting in the deal, they have to believe it too.
Your ability to forecast cash flows is a very important skill as you can see. (review last week’s episode and the links to the training if you want to learn more).
“But what if I want to get in the self storage business, but I don’t have 25% that most banks require?”
There are other types of loans available to you today for self storage.
SBA, Small Business Administration, loans are now available for self storage.
The SBA mission is to help small business owners, like us, start a business. They offer to sell their cash on terms that are better than normal banks to help us.
In reality, what they are doing is ensure the banks so that the lender doesn’t carry all the risk. If you default, the government (the SBA division of the government) will pay the bank back a large percentage of the money they loaned you. In reality, the SBA is an insurance program from the US government to the banks to incentivize them lend you the money on favorable terms.
How favorable?
Usually, they can loan up to 90% of the cost of the facility.
Their period of amortizing the loan is longer too than most normal bank financing. So even though their interest rate is higher than normal banks, the payments are about the same. How long a loan amortizes has more to do with how much it is rather than the interest rate.
Finding a Lender
When you are preparing to go to a lender, you are preparing to tell a story.
The story is about the project you hope to buy. You are going to show them, with your financial analysis reports, why you want to buy this facility and why they are safe lending you the majority of the cash to do so.
The binder I create usually consists of:
- A 1-2 page Executive Summary
- The Financial Analysis Reports
- The Feasibility Report (or I let them know one has been ordered)
- The marketing package
- Some historical financials I get from the Seller
- My group’s resume
I spend most of my time going through the financial reports. Use that time to tell a story that shows 1) why this facility and 2) why you.
When you are borrowing money for a commercial real estate investments banks are more interested in you than the project. They would rather lend to a good operator on an OK deal than and OK operator on a good deal.
The Loan
Many people I work with are not sure if they can qualify for the loan by themselves.
I get this. In many cases, I can’t either.
That is one of the reasons I have partners.
If you are not sure if you can qualify, meet with a banker or lender and discuss it. Realize that the day you close on the facility, your income just went up (assuming they are getting rent and it isn’t a ground-up project).
I looked for partners that could help me run the business, had skills I didn’t have, and some net worth that would help me get loans.
Ultimately, they bought into the vision I had for a self storage company and said they wanted to be a part of it.
Together we are moving forward (sometimes backward as well). Without them, I couldn’t run the business and/or get the loans needed.
At least for me, partners are awesome. I would only own one or two facilities if it was just me. Nothing wrong with that, but it wasn’t my vision.
There are ways around all the issues you may have in getting into the self storage business. Understand that you should not jump at the first loan – which I have done. You should get multiple offers with options to choose from (again something I haven’t done int he past and regretted).
The loan represents the majority of the money going into the deal, so make sure you get the best terms on the money you can.
Nothing is less fun than working with a bank that is not easy to work with. I have many stories I could tell. However, in the end, it was all my fault for not having enough options and not choosing the best option for us at that particular time in our evolution.
Make sure you have the time you need in the due diligence phase to get the right financing for you.
Leveraging low-cost money is one of the best ways to create true wealth in the fantastic business of self storage.
