Underwriting Self-Storage Properties
Underwriting is the process used to determine the financial feasibility of an event such as the acquisition, refinance, recapitalization, construction, or expansion of a property. This process is integral to any real estate transaction and the product of the underwriting will be a primary decision making factor for every party involved, from the operator, to the lender, and ultimately to the investor.
In the 1970’s during the Vietnam War, when General William Westmoreland was confronted by reporters’ questions about the US army’s strategic shortcomings, he would respond with the self-coined acronym, “SWAG”. SWAG stands for “Scientific Wild-Ass Guess”, a not so diplomatic way of describing an estimation made by a field expert on the basis of sophisticated assumptions and methodology. While underwriting is vital to any real estate event, it is important to remember that it is never conveying guaranteed results and the associated risks must be understood – No one has a crystal ball.
The underwriting process involves three primary decision making parties: operators, lenders, and investors. Operators want to build enough value into a facility to be able to make money, lenders want to ensure that borrowers are able to repay loans, and investors want a competitive return on their money.
The Operator
Operators use the knowledge they’ve gained through market data and operating history and apply it to a specific project. They analyze what has been done in the past in order to best make an estimate of profitability. Sophisticated methods are used to project what can be done with the property from an operational standpoint. To accomplish that outcome, the Operators will look at what capital improvements and costs of restructuring management are necessary.
The surrounding market conditions and historical performance of the property are analyzed for key data points including occupancy, rental rates, property taxes, payroll, and insurance. This information is used to determine a price for the property that will enable repayment of the loan at a certain rate, give the investors a return at a certain rate, produce sufficient cash flow and build enough value into the facility for the operators to make money.
Once a purchase price is chosen that will enable the operator to build value, repay the loan and provide investors with a competitive return, that price is negotiated with the seller. If an agreement is reached at or below this purchase price, a contract is entered into and a lender is secured.
The Lender
The lender’s primary concern is the borrower’s ability to repay the loan. The yield (profit from lending money) must sufficiently compensate for the risk. This is where metrics like the debt-service coverage ratio (DSCR) come into the picture. DSCR is a measurement of the cash flow available to repay the debt. It’s calculated by dividing net operating income by the total debt service. In other words, if operating income is $10,000 and debt service is $5,000, the DSCR is 2x. Lenders use the DSCR to analyze how large of a commercial loan can be subsidized by the cash flow generated from the property.
That being said, real estate is one of the most highly leveraged assets because the land and the structure make it a secured debt. Banks are comfortable lending 60-80% of the cost to buy the property because they can foreclose and have a better chance at recouping their money.
Commercial loans typically have a prepayment penalty, allowing the lender to continue to make money even if the borrower chooses to refinance at an earlier date.
Another factor to consider is a balloon payment – a large payment that is due at the maturity of the loan. Balloon payments are typical on commercial notes. These notes are generally 2-10 years but amortized at 20-30 years. The lender needs a level of confidence in your business model to be able to refinance or sell the property to make the balloon payment.
Passive investors are ordinarily not interested in the details but in the product of the underwriting.
The Investor
Investors want to know how much money they’re getting and how they’re getting it. Are they receiving regular payments for a specific term or are they waiting for the big payoff when a sale or recapitalization takes place? The equity multiple is an easy way for an investor to measure an investment’s performance.
The equity multiple is the total cash distributions received from an investment, divided by the total equity invested. If it is less than 1.0x that means you are getting less cash than you invested. An equity multiple of 2.0x means that you’re getting 2 times the cash you invested.
Keep in mind that there is always an opportunity cost when you invest. Opportunity cost is the loss of potential gain from other alternatives when one alternative is chosen. For example, if you are a $100 per hour consultant and you decide to spend four hours playing golf instead of working with a client, your opportunity cost is $400, plus your greens fees, cart fees and any additional expenses related to the game. The same is true of the investment. Due to inflation, $1 invested now is probably not going to be worth $1 at the end of the year, or it could be worth more used in alternate ways. Underwriting helps an investor to make the best decision as to how to grow wealth.
Final Thoughts
Self-storage underwriting is like painting a picture based on assumptions of what you think you can reasonably achieve in a transaction. All of the elements have to blend so that the final product is a masterpiece of financial feasibility for all concerned parties.
If you’re interested in learning more about the process, Pinnacle Storage Properties has a proprietary underwriting model that is a macro enabled Microsoft excel spreadsheet that you can license. For details, contact Ross Smolen at Ross@pinnaclestorageproperties.com.