Creative Self-Storage Solutions – Reducing the Cost of Capital in a Storage Deal

The cost of capital is high today to do a Self-Storage or Boat & RV development today.

Let’s look at a creative way to reduce this cost of capital and perhaps solve another problem for us smaller developers if we are using other people’s money and/or syndicating a deal today.

In full disclosure, I have not done this technique yet, but am in the process of a development deal we have control over. I have run this idea by my attorney and received a blessing. So, I thought I would share it with you guys. I am in the process of doing this now.

The Good Old Days

In the good old days (pre-interest rate hikes), I repeatedly (probably over 1,743 times in these episodes) said that bank money is the cheapest money in the “capital stack.”

What I meant was we could borrow, let’s say, 75% at 4.5% and raise 25% at 8% or 9%. If you are not raising money but using your own, you probably want at least a 12% or 15% return minimum, but for our example, let’s use 9%.

So, in my syndication of a development deal, let’s say a $2.5 million deal and offering a 9% preferred return (what I was offering in 2018 & 2019). The “capital stack” (how do you like that fancy term) would look like this:

Development Deal Cost					$2,500,000
Bank Loan			4.5%	75% LTV	$84,375
Investor			9% Preferred	25% Equity	$56,250
Total Cost of Capital					$140,625
Total Cost of Capital As A Percentage					5.63%

Those days are gone.

Today’s Reality

Let’s look at the same deal today.

It is a weird time when the cost of bank money is more than investor money.

But that is the reality today for most development deals.

Why? Because most value play or development deals have construction involved, and the loans are tied to the prime rate. Prime rate is 8.5%.

The last Loan Commitment we received was .75% over prime. So, my construction rate was 9.25% during the interest-only period. It was going to take at least 36 months to rent up.

The preferred return we are offering today is 8%, less than the interest in many cases.

Sometimes sponsors can offer 7%, but still, it is mostly 8%, I see.

So, let’s look at the same deal and the cost of capital today assuming we could get a 75% LTV.

Development Deal Cost					$2,500,000
Bank Loan			9.25%	75% LTV	$173,438
Investor			9% Preferred	25% Equity	$56,250
Total Cost of Capital					$229,688
Total Cost of Capital As A Percentage					9.19%

In this fictitious deal, my cost of capital for the same size deal has gone up $82,813 per year.

If one is syndicating, you may ask, “Well, why don’t you just raise the $2.5 million and have an 8% cost of capital?

That can work, but (1) it is still $200,000 per year, not to mention it is harder raising capital today than it was a few years ago.

So, I have been looking at creative ways to keep my cost of capital down.

You could say the obvious answer is Seller Financing.

That can work and can help, but in this scenario, the Seller would have to take a second mortgage or subordinate behind a bank. Most won’t do that.

Remember, I usually need cash…real money to buy building systems and pay sub-contractors.

Banks and investors have cash. Seller financing land usually does not.

Thus, we went back to a creative way to reduce the cost of capital even a little.

DST’s

I have been watching the rise of DSTs over the last few years.

A DST is a Delaware Statutory Trust.

This is an investment vehicle that allows people to 1031 their money their sales proceeds into a deal as a passive investor.

A few years ago, I looked at forming a DST, but the vetting process and the ongoing cost and SEC regulations made it a business I was not to excited about getting into.

I’m more of a storage guy.

But I am still fascinated with them.

Why?

Well, because, in essence, they are just a syndication that pays 5% or 6% today.

And people flock to them because it is a way to avoid capital gains.

Now, if I went to an investor with a deck for a deal and said I would give you a 5% return, not many people would be excited.

But, If I went to an investor and said I would give you a 5% return, and you don’t have to pay capital gains on the deal you just sold generating the money, I bet I would sell out.

Especially on day 44 during the identify stage of a 1031 time period.

People (including myself) do very different things when the clock is ticking and a six-figure capital gain is looming.

Now I don’t want to do a DST, but I was trying to figure out how have something people in a 1031 with the clock ticking would look at my deal at lets say a 5% or 6% cost of capital.

Then it hit me.

Now, in truth, I found out this, or some version of this,  has been done before, but I had never heard of it before I started exploring it.

Land Lease

In the potential development deal I am contemplating, the land cost is $3.5 million and the development cost are around $16 million (a mixed use Boat & RV and Flex Space deal).

Given it is a ground-up deal, at best, I am going to most likely  get today is a 70% LTV loan.

Let’s look at the capital stack in this deal going the traditional way today: bank and investor equity.

Development Deal Cost					$19,500,000
Bank Loan			9.25%	70% LTV	$1,262,625
Investor			8% Preferred	30% Equity	$468,000
Total Cost of Capital					$1,730,625
Total Cost of Capital As A Percentage					8.88%

 

1031 Problems

One of the things I have seen as a Broker today is that the majority of 1031s that are trying to happen don’t.

People can’t seem to find suitable replacement properties.

Hanse, the rise of DST’s.

So, I started thinking about what I could go to them with.

I started looking at land leasing the land to someone in 1031.

My thought was to create a land lease someone could 1031 into.

Then the developer would lease the land back during the development process, and when the project is stabilized, they Lessor on the land lease will exchange their land lease into the development and get equity in a larger and more profitable deal.

On our deal, when stabilized, we are projecting a $26 to $27 million value at a 7% CAP.

The development and lease up is the riskiest time period, and the person going into the land lease will get a lower steady cash flow at 5%, or so, but after stabilization, they can roll into the deal and get a much higher return and share in the equity created.

We anticipate that to be year 4 or 5 of the deal.

The benefits to them are:

1. Avoid capital gains by taking title to land.
2. They can get a DST type of return during the development phase of a project.
3. Reduce their risk and own an asset during the riskiest time in a project.
4. Roll their asset into the deal after it becomes profitable and participate in the deal’s upside.

You may say, well, won’t that trigger a gain when they roll into the deal?

Yes, probably.

I anticipate they would do that at the time we do a cash out refinance and put a non-recours loan on the deal.

As a sponsor, I could take some of the refinance proceeds, fund their gain, and then reduce the value of the lease by that amount to determine the amount of equity they get in the deal. They don’t have to come out of pocket with cash themselves at that time.

Benefits To Sponsor:

1. Reduced the cost of capital almost 1% or $135,000 per year (see below).
2. Reduced amount of equity needed to raise by $1,755,000.

Development Deal Cost					$19,500,000
Land Lease			5%	$3.5 land value	$175,000
Bank Loan			9.25%	70% of dev cost	$1,036,000
Investor			8% Preferred	30% Equity	$384,000
Total Cost of Capital					$1,595,000
Total Cost of Capital As A Percentage					8.18%

The yearly cost of capital during construction went from $1,730,625 to $1,595,000.

We are only limited by our thinking and creativity.

Let me know if you have used other creative ways to move forward in growing your portfolio during this interesting period of the economy.

The game is to get assets now, then when interest rates and CAP rates drop, sell or refinance.

I don’t want to wait until then to get in. That is when I want to get out or refinance and move forward.

Let me know your thoughts.