Self Storage Investing Newsletter

The holiday shopping season is here. That’s great for the self-storage industry – it means more items that need to be stored. We often wonder what percent of all self-storage units in the U.S. contain a Christmas tree. It’s got to be at least 75%. The Christmas tree and holiday gift season has to be the MVP of storage demand. At the same time, the holiday season is a great time to enjoy terrific decorations, great food, and a chance to reconnect with family and friends in a joyous atmosphere. On that note, we’d like to say MERRY CHRISTMAS to our extended “self-storage family”. We hope that you and your family have a tremendous holiday season and look forward to a successful 2015.

People always ask us how we get such good returns on self-storage facilities. The answer is simple: the “spread”. We’re not talking something we picked up at a cheese store along the Interstate. We’re talking the “spread” between interest rates and cap rates. That’s what really makes deals work, yet few people ever discuss it publicly (maybe so nobody else knows the trick).

Spread is the difference between cap rate and interest rate

If you buy a self-storage facility at a 9% cap rate, and finance it with 5% debt, then your “spread” is 9 – 5 = 4. With a 4 point spread, here’s how the numbers work out. Assume you buy the self-storage facility for $1 million, with $200,000 down. You buy it at a 9% cap rate and you finance it at a 5% interest rate. Under that scenario, your $200,000 with garner a 25% cash-on-cash return. It’s just simple math, and the magic of sensible leverage. What if you’re deal is $500,000 with $100,000 down? Same thing: 25% cash-on-cash return. That’s why real estate has been one of the top investments in the U.S. for a hundred years – the odds are stacked in your favor as long as you maintain a healthy spread.

The spread is what really dictates your cash-on-cash return

If you lower the spread, the returns diminish rapidly. A 2 point spread on this same deal, for example, would yield only a 17% cash-on-cash return. A zero point spread yields a 9% cash-on-cash return. But then things get ugly if the spread goes upside down. Even a 1 point negative spread will bankrupt you on a cash flow basis. So spread is one of the most important – if not the most important – indicators on your instrument panel.

How to maintain a healthy spread

You maintain a healthy spread by doing fantastic due diligence, and buying properties that have the ability to maintain that spread through higher rents and occupancy. Benjamin Franklin said that “diligence is the mother of good luck” and he was 100% correct. You cannot afford to have any surprises on the property you buy, as that’s going to negatively impact the spread. To maintain a healthy spread going forward (given that interest rates are likely to increase in the years ahead), you will need to buy properties that have the ability to increase rents and occupancy on a continual basis. If you buy a self-storage facility that is 100% full and a very high rate, you have no way to offset any interest way increases, and could end up in financial trouble on that deal.

The future of interest rates

Interest rates are at historic lows right now. They run in cycles. It’s hard to imagine that they will not increase in the years ahead. Because of the cyclical nature of interest rates, it’s always a good idea to do “fixed” rates instead of “variable” rates on all bank loans. Additionally, you need to buy only facilities that have the ability to offset all interest rate increases point-for-point through higher net income. Maintaining the right spread is as important as bailing water out of a boat.

Conclusion

Self-storage facilities have great returns. The root of those returns is “spread”. You need to understand this concept and embrace the need to keep interest rates low and cap rates high. Leverage is a great tool, as long as you understand how to use it. Stay proactive on spread and your investment will do fine.

A conduit loan, also known as “Commercial Mortgage Backed Security” or “CMBS” loan, is a loan that is created at a bank and then sold on Wall Street in bundles with other loans. These “bundles” are often hundreds of millions of dollars, and are considered safe bets by investors seeking higher returns than those provided with CDs ad Treasuries. Many self-storage facility loans are found in this loan product.

Conduit is a complex type of loan

Conduit is actually a very complex loan type. Although they are originated at normal banks like Wells Fargo and Citigroup, once they have been “bundled” and sold on Wall Street, they are no longer normal bank loans. Instead, they become a non-bank product. This means that, instead of a loan officer, you are assigned a “servicer” who is your contact regarding the loan. And there is no ability to renegotiate the loan if the borrower runs into trouble, because the loan is owned by investors and not a bank.

Unbelievably attractive terms

The hallmark of conduit loans are incredibly attractive terms for the borrower. You get a low, fixed interest rate, and a typically ten year term. You can ride out the interest rate cycles in the U.S. for a decade without a care in the world. In addition, the loans are assumable by a buyer. Of all the loans we do, we prefer conduit to any other loan type, except for seller financing.

But be careful of defeasance

The big trade-off for those great loan terms is the fact that it is difficult – or even impossible in the first few years – to prepay the loan. This means that, if someone wants to buy the property from you in that ten year term, they will have to either assume the loan or pay a huge penalty to pre-pay it. That penalty is called “defeasance”. It is extremely difficult to calculate defeasance, and there is a whole website devoted just to coming up with the number: www.defeasewithease.com. The defeasance penalty is gigantic, because you have to buy enough Treasuries to make all of the payments, with interest, until the end of the loan term. We’ve seen defeasance of $500,000 on $2 million loans. So don’t do a conduit loan unless you’re in it for the long term.

How to get one

The easiest way to get a conduit loan is to use a loan broker. They typically charge a 1 point fee to find you a bank and get the loan done. Our favorite loan broker is Security Mortgage Group at (585) 423-0230. We have used them on around $100 million of conduit loans over the years. It is too hard to get a conduit loan on your own, in our opinion, as the players change constantly and the application process is cumbersome.

Conclusion

Conduit loans are a great way to finance self-storage facilities. You need to know how to get them and how to use them properly. They are a terrific tool and one that we recommend heartily.

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