The most dangerous – and profitable – tool in buying self-storage facilities is debt. It can either greatly enhance your rate or return or drag you down and drown you. In this Self-Storage University podcast we’re going to explore debt, how it works, and what the pitfalls are at a time when interest rates are at 40-year highs.
Episode 85: The Best And Worst Too To Make Or Lose Money Transcript
A hammer is a wonderful tool. You can nail in a nail with it, but you can also hit your thumb. This is Frank Rolfe, the Self-Storage University Podcast. We're gonna talk about one of the biggest tools in self storage and investing, but that can also be a weapon that injures you if you don't use it correctly, and that one big tool is leverage or debt.
Now, what you need to know about debt is that debt allows you to amplify your rates of return, and that's why people like real estate because, it's really hard to get debt when it comes to like owning a business. Most banks, they don't feel comfortable making big loans on a business. They don't know how you'll do with it. Businesses fail all the time. But a self storage facility seems somewhat stable, right? It's real property, it's sitting there, it has customers, and banks can get comfortable with that permanence and that stability, so they're willing to make a loan.
So what happens when they make you a loan? Well, typically you put some form of down payment, and in exchange, they issue you a mortgage, and that allows you to buy things that are way beyond your ability to buy for cash. So if you have $100,000 in your pocket, you could buy a $100,000 business or franchise, or you might be able to buy $0.5 million of self-storage facility. Just hold onto it, make the payments every month, 20 years, 25 years later, you own it free and clear. So you levered that $100,000 into a $500,000 asset plus whatever the value is at that point.
Also, if you buy something with leverage and there's a spread between the cap rate on the self-storage facility and the interest rate, it spikes your rate of return. A one point spread between the interest rate and your mortgage rate can take you up to about a 12% rate of return. A two point to about a 16%, and a three point to over 20%. Now, if you didn't use leverage, let's run those same numbers. If I buy something at a 8% cap rate and I borrowed it at a 6% mortgage, that two point spread would get me 16%. But if I didn't have leverage, if I paid cash for it, it only gets me 8%. So I've almost doubled my rate of return by useful methods of that tool, that tool of leverage.
But here's the bad news. If you play it the wrong way, if that leverage tool, instead of hitting the nail hits you on the thumb, it can hurt really, really bad. In the same manner that those spreads can boost your return, they can also pull you underwater and drown you, because the problem is that leverage basically amplifies whatever you do. It amplifies the good, but it also amplifies the bad.
You probably have heard recently of different businesses that have gone into bankruptcy, I think Joann Fabrics is rumored to be next up, because they have a whole lot of debt, and at the time, it seemed to make sense, they had a whole lot of debt because they were doing well, but when times got bad and they weren't doing quite so well, that that debt is like a giant Lead weight chained around their necks. That's the problem with debt. It can be great, it can be good, and it can also be terrible.
Now, what does it mean for the self-storage industry? Well, a whole lot of people bought a whole lot of self-storage back when interest rates and cap rates were very, very low. If you bought a self-storage facility, for example, at a four or five cap, within the last few years, you're in deep trouble probably because those cap rates have increased enormously as interest rates have gone up. You've seen one of the largest rises in rates ever in the last year, 40 years ago is last time you saw rates as high as they are currently. And so that cap rate is readjusted, and so is that mortgage. And then you get the double whammy, because now not only are you being punished every month because you're making a giant mortgage payment, don't have the money to pay it, but the other issue is when your note comes due, what do you do then when that balloon payment hits? They appraise your property now based on the new cap rate and the new mortgage rate, and you can't get a loan as big as you had before. Then what do you do? Well, you're in real trouble. You may even lose the property.
So how do you mitigate that risk? Well, people have always tried to figure out how to mitigate the downturn, the danger parts of the tool. Like what do you do with a hammer? Could you have a hammer where if it only hits the nail, it's rock solid, but if it hits your hand, it's a marshmallow? Well, one way to do that in lending is to do's called non-recourse debt. That lowers the burden, it softens the blow. If you have non-recourse debt and the property goes back to the bank and it's sold at auction for a loss, at least they can't come after you for the deficiency. And that's a big deal, because the deficiency could just drown you.
Long before Jerry Jones owned the Dallas Cowboys, they were owned by Clint Murchison. Clint Murchison made a lot of money in the oil industry, or at least inherited a lot of money, but the problem is he wanted to be a big shot. So rather than just be a wealthy oil guy, he decided to expand massively into real estate, and he bought a huge amount of real estate that was really, really poorly timed. He bought it with interest rates were very, very low. And then suddenly when the interest rates rose, he was in deep trouble. He was upside down. He tried to unload it all, but he couldn't. He couldn't even sell the stuff for what he paid for it. And when finally the banks took action and they sold it all off at auction, he didn't have enough to cover the notes. And he signed what's called recourse debt, so they come after him personally, and that's what forced him to sell the Dallas Cowboys.
When you have a non-recourse loan, what happens is, when the debt comes due and if you can't cover it and the bank takes it back and sells it at auction and there's a loss, they cannot come after you personally. The most you can lose is your down payment. So recourse is one method that people use to try and save the day.
Another one is the length of the notes itself. If you do a three-year note or two-year note, you're in a much greater jeopardy than if you did a 10-year note, because that 10-year note gives you the ability to weather the storm and interest rates rise and fall and rise and fall, because nothing matters until that note comes due. So having a longer maturity on your debt is another great way to turn that hammer back into a marshmallow.
Yet another thing you can do is simply not use a lot of leverage. Public storage does that. They use very, very low loan to value as far as leverage. But the problem with that is, for most people, that may preclude you from being able to buy anything. If you say, well, I'm only gonna buy things for 50% loan to value. Instead of buying that $500,000 facility for a 100,000, you're stuck with a $200,000 facility. So lack of leverage may not really be the answer for many people.
So what does that leave you? Well, it leaves you one final item, and that is just doing really smart buying. Buying properties properly and doing great due diligence, that's probably the best answer of all, because that gives you the best opportunity to not hit the bad side of the hammer. And right now what you have good on the storage facility is you have a dichotomy. You have basically two different industries operating both under the self-storage label. You have the urban part of the industry. Those big facilities, often multi-story, sometimes climate-controlled, and they're just dying right now. A recent announcement by the Self-Storage Association, I can't remember exactly which one, it showed that basically rents are down about 10% and occupancy is down about 10%.
So if you add that together, that's a catastrophe. And the reason you're seeing that is many Americans are fleeing the city. They're running away. They want nothing to do with it. Too much crime, too much congestion. They just don't wanna live there anymore. And most of those multi-story, climate-controlled, fancy storage facilities, that's exactly where they're located at. They're located right in those urban metro markets that people are running away from.
Then however, you have the self-storage industry that's based more out in the suburbs and exurbs, and in those areas, people are having increasing occupancy and increasing rents, and it's simply because that's where Americans are going. They're all leaving the city and they're pushing farther out. Those facilities look nothing like the ones that are urban. They're never too story, rarely climate-controlled. It's normally just your classic drive on up and roll up the door, but that's what people want and that's where people are going.
The bottom line to it all is be very, very careful when you sign that loan that what you're doing is smart, and that you're not getting into a position where that tool that you're so excited about can be used against you as a weapon.
This is Frank Rolfe, The Self Storage University Podcast. Hope you enjoyed this. Talk to you again soon.