Bank interest rates are at the highest level in the past 40 years. But it still doesn’t make sense to buy a storage facility with all-cash. In this Self-Storage University podcast we’re going to discuss why buying properties with 100% cash and no debt is not a winning concept except in certain circumstances.
Episode 98: The Problem With Cash Transcript
Sure, bank debt interest rates right now are at their highest level in the last 40 years. Since Q1 of 2022, rates have been going up almost straight vertically, and the fed funds rate jumped from about 0.25 to about 5.5, and that may make you think, well, maybe I need to buy a self storage facility using just all cash. If that's the case, you wanna listen to this podcast. This is Frank Rolfe, the Self Storage University Podcast. We're gonna talk about the problems with buying any kind of storage property using all cash. Now, let's first look at your REITs public storage. The largest of the REITs, do they use all cash? And the answer is no. They use a blend of debt in cash, as do all storage REITs. In fact, all REITs in America use debt in cash. Now, why are they using debt and cash?
They're using debt and cash because it's the leverage that you can obtain in real estate that gives you the higher rate of returns. So you really can't hit high rates of return with real estate if you use cash. If you wanna hit a 20% cash on cash return with your storage facility, you'll have to have a three point spread between the cap rate and the interest rate. Assuming the 70-80% loan to value, if it's just 1 point, it's about 10%, 2 points about 15, and 3 points about 20. But if you buy something with all cash, the highest rate of return you will have is simply the cap rate on the facility. So if you were modeling that, let's assume you were able to buy a self storage facility with a loan at 6%. If you could buy it at a cap rate of 7%, in that case, you would have a 10% cash on cash return due to the leverage.
But if you didn't use debt, you would have only a 7% return. So it's a huge difference by using debt instead of using all cash. But there's other problems beyond that with using all cash. One big problem you have is when you use all cash and you don't use a bank, you lose that extra set of eyes, and that's a very knowledgeable set of eyes on your deal. You can never look at a deal enough times to make sure you're not getting in trouble, and there's no greater way to potentially help yourself get in trouble than to take the bank out of the equation because with the bank also comes a formalized appraisal, and that's yet another set of eyes. So someone buying with all cash, they're the only ones who really look at the deal and make a decision. But when you use bank debt, there's not one, not two, but three different groups that look and bless the deal.
You, the buyer, then the appraiser, and then the bank. So you're gonna lose two thirds of all of the extra scrutiny you had when you use all cash. Another problem can come in if you buy it all cash with the understanding you'll refinance later. And then you come to find out that there's a problem with the property that any bank would've caught. And since you didn't know about it, now you can't get it refinanced. That would be a disaster for you, right? If you said, well, I'm gonna buy it for all cash and I'm gonna refinance it in three years, and then three years later you come to find out you can't get it refinanced at all because it's lacking some attribute that bankers are gonna require or some permit or license or something and now you can never get your cash back out. And then of course, on top of that is you can't really sell it either because it's missing this item.
And now if you go to sell and they have to get a bank loan, then that's gonna create a problem. Remember that in all of real estate, very, very few people buy with cash. If you go out and advertise a property for sale with cash or cash only, and don't let them get a bank loan on it, well, that's gonna preclude literally 99.999% of all potential buyers. And then don't also forget that if you use your cash to buy all the storage properties, you're gonna run out of cash much faster than if you did traditional banking. If traditional banking is 20 or 30% down with that same amount of cash, you could buy either one self storage facility or five. So using cash will get annoying pretty quickly 'cause you will literally run out of gunpowder to buy new stuff.
Now, it's very, very important to remember that if you go in with the attitude that I'm not going to buy it with cash and bank debt doesn't work, that may steer you into seller financing because debt is debt. It doesn't matter whether it comes from a bank or through a seller, and in fact, the seller is probably the more attractive option really in the long run. Seller debt is typically non-recourse. It's a lower interest rate. It also allows for a lower amount down, but you need to fight against the concept of ever using cash. The only time you could ever use cash and not feel that it was a foolish idea would be if you were buying a self-storage facility at an auction. Let's say there was a bank foreclosure and it went to auction. In those auction situations, you typically have to put down 10% of the price that you just bid right then, and then the other 90% within 30 days.
It's really hard to come up with cash like that. Very, very difficult. Very, very stressful to be in that position. So that's one time in which using cash might be okay, but it's pretty much the only one. So when it comes to buying self storage facilities, you need to set a line in the sand. "No, I'm not going to pay all cash, if I can't get bank debt that's gonna work on this deal, I'm gonna get seller financing, but I'm not gonna stick all my capital into one deal." Because I'm pretty sure later on you'll regret it. This is Frank Rolfe, the Self Storage University Podcast. Hope you enjoyed this. Talk to you again soon.