The Underwriting Procedure for Analyzing a Self-Storage Investment.
It is indisputable that Americans are addicted to self-storage facilities. A staggering number of these amenities are on highways, city streets, and rural roads. As an investment option, they provide substantial returns. However, many novice real estate investors lack expertise in assessing these transactions. This post will thus discuss self-storage property underwriting.
Specifically, we will discuss the following step-by-step method for underwriting a possible self-storage deal:
- A Summary of Self-Storage Investment
- Step 1 of Self-Storage Lending: Confirm Unit Rents
- Step 2 of Self-Storage Financing: Confirm Operating Expenses
- Self-Storage Underwriting Step 3: Determine Property Value
- Step 4 of Self-Storage Lending Approval: Permanent Financing Availability
- Step 5 of Self-Storage Property Appraisal: Confirm Acquisition/Renovation Budget and Financing
- Self-Storage Financing Step 6: Forecast Cash Flows and Evaluate Investment Criteria
- Final Reflections
An Overview of Self-Storage Investing
Self-storage investments provide investors with substantial upside potential. In addition to good cash flows, these assets exhibit anti-cyclical performance, making them an excellent hedge for a property portfolio.
The success of several forms of commercial real estate corresponds with the status of the economy. In other words, the properties do well in prosperous times. In economic downturns, however, they do poorly. Typically, self-storage units function differently. When the economy shrinks, two things often occur:
- People are moving into smaller houses and flats.
- Individuals return to school.
Individuals must locate storage for their surplus things in each circumstance mentioned above. Tiny houses, college dormitories, and apartments have limited room. And when we downsize, we naturally urge to keep items rather than sell or discard them. This fact prompts individuals to hire storage containers. As a result, when the economy slows, self-storage demand frequently rises, as does property performance.
The hedging phenomenon attracts many commercial real estate investors to self-storage facilities. In the residue of this post, we will describe how to analyze possible self-storage purchases to determine if a particular facility is a good fit for your portfolio. Expressly, the processes outlined below assume that investors want to A) acquire a self-storage facility using short-term financing, B) undertake value-adding modifications, and C) refinance the property into a long-term mortgage.
First Step in Self-Storage Insurance: Confirm Unit Rents
To underwrite a self-storage transaction, investors must first forecast stable (i.e., post-renovation) operational performance. These anticipated functional outcomes, often known as pro formas, assist investors in predicting future property returns. To construct these tools, we suggest starting with the most critical metric: unit rentals.
During the due diligence phase of any transaction, investors must gather comprehensive data regarding each storage unit (e.g., square footage, current rent, lease terms, historical vacancy rates, etc.) and the property as a whole. This data will present as the basis for our study. However, as said, we want to add value to this property, which means we anticipate future rent increases. This premium varies with each transaction. However, investors may calculate a fair compensation by analyzing the rental comps of adjacent self-storage facilities. Investors may discover, for instance, that by installing security cameras and an electronic entry gate, they can boost unit rentals by 20 percent.
Self-Storage Underwriting Step 2: Confirm Operating Expenses
Following the projection of future rents, investors must validate projected operational expenditures. Typically, value-added enhancements in self-storage facilities do not impact the units themselves. A storage unit is unexceptional. Instead, investors focus on enhancing auxiliary services. You may want to add on-site management, install security cameras, pave a formerly gravel lot, or add additional improvements that raise the property’s efficiency and value.
When evaluating these enhancements, recurring expenditures must be added to the current operating expenses. In other words, the monthly price will be included in your stable operational costs if you want to situate a security system. The next step for investors is to mix these additional expenditures with the current operating expenses. The outcomes of the past may give crucial knowledge. For instance, if you examine your power use over the last three years, you may adequately predict future electricity costs.
Although operational expenditures vary by property, the following are similar to all self-storage facilities:
- On-site management charge (as required)
- Security system fees (automated and/or manually collected).
- Utilities
- Cleaning fees
- Marketing fees
- Real estate taxes
- Insurance
- Maintenance
- Accountancy costs
These expected operational expenditures complete the pro forma. Once validated, investors will understand stable net operating income (NOI) or rental income less operational expenditures.
NOTE: Operating pro formas do not cover renovation and enhancement expenses. These are costs capitalized that are included in the property’s taxable base, not its operating income. In addition, mortgage interest and depreciation are not operational expenditures. Hence they should not be included in an operating pro forma (we will account for these expenses later). Instead, these two costs fall “below the line” – they are included in net income but not net operating income.
Self-Storage Underwriting Step 3: Determine Property Value
After constructing an operational pro forma for a stable property, investors may evaluate its after-renovation value or ARV. This score determines the availability of permanent funding and may make or break a transaction. Investors utilize the commercial value calculation for this purpose:
Property Value = NOI / Capitalization (“Cap”) Rate
The pro forma supplies the NOI, while the market and the property’s quality determine the cap rate. Cap rate conceptually depicts a property’s return on an all-cash transaction. For example, if an investor acquires a $1,000,000 property with cash, a $50,000 NOI corresponds to a 5% cap rate ($50,000 NOI / $1,000,000 value).
Generally, the lower the cap rate, the more stable and high-quality the property is. To establish the cap rate of a self-storage facility, investors must consider A) the property’s quality compared to comparable self-storage facilities and B) the local market circumstances (real estate analytics firms can provide this insight).
This commercial value formula is incredibly crucial for investors. A little rise in NOI may significantly impact the value of a property. Assume, for instance, that property renovations cut operating expenditures and boost rent, resulting in a 20% gain in NOI. With these figures, NOI jumps to $60,000 from $50,000. This boosts value from $1,000,000 to $1,200,000 at a cap rate of 5%. And suppose that the improvements in quality also decreased the cap rate from 5% to 4%. Now, the property’s worth is $1,500,000 ($60,000 in net operating income x 4% capitalization rate).
Clearly, self-storage property enhancements may have a multiplicative influence on a property’s value, directly relevant to the subsequent underwriting phase.
Underwriting Self-Storage Step 4: Back into Available Permanent Financing
Using the estimated after-renovation value, investors may “back into” available permanent finance. As previously said, most investors acquire self-storage facilities using short-term commercial bridge loans, make modifications, then convert the bridging loan into a long-term mortgage.
Similar to their residential counterparts, commercial mortgages operate on a loan-to-value (LTV) basis. That is, lenders will provide loans depending on the assessed worth of a property. For business mortgages, the majority of lenders provide loans up to 75% LTV. Using the aforementioned figures, investors may anticipate a mortgage of $1,125,000 ($1,500,000 ARV multiplied by 75% LTV). This loan amount offers investors essential direction. This information lets customers know they may refinance a bridge loan of up to $1,125,000. The purchase and renovation costs will be based on this ceiling in the subsequent stage.
Underwriting Self-Storage Step 5: Confirm Acquisition and/or Rehab Budget and Financing
Budgets for purchasing and renovating a self-storage facility are capped by the permanent financing specified above. In other words, investors want to verify that the permanent financing with a lower interest rate can completely repay the bridge loan with a higher interest rate.
However, finding the precise budget for the renovation involves careful collaboration with the general contractor. In addition, value-added renovations for self-storage projects will likely include significant automation and security upgrades, which will need the assistance of professionals. With the aid of this team, investors validate their rehabilitation budget. Assume, for example, that it will take $200,000 in upgrades to provide an increase in NOI by over 20% (a combination of increased rents plus reduced operating costs because of automation). Add this to the $1,000,000 buying price, and investors will require a total of $1,200,000.
There are several choices for short-term bridge loans. However, most lenders base their loans on the ARV of the property. Common terms provide up to 60 percent of an asset’s after-repair value but no more than 90 percent of the purchase price. To calculate the loan amount, we must thus consider two numbers:
- 60 percent of ARV is $900,000 ($1,500,000 multiplied by 60 percent)
- 90 percent of the purchasing price is $900,000 ($1,000,000 multiplied by 60%).
Since these data indicate, investors may anticipate qualifying for a bridge loan of $900,000, as the 60% ARV does not surpass the 90% purchase price (if it did, investors would be limited to the 90 percent ceiling). This number requires a dual perspective. First, investors must affirm that their permanent finance will be sufficient to repay the bridge loan. At the fourth step, we confirmed an endless financing sum of $1,125,000. This gives a $225,000 cushion for short-term loan interest payments, typically added to the loan total until a certain period ($1,125,000 permanent mortgage – $900,000 bridge loan).
However, investors must evaluate this bridge loan amount through the prism of contributed capital. As mentioned, the budget for acquisition and renovation totals $1,200,000 ($1,000,000 for the acquisition plus $200,000 for capital upgrades). The bridge loan, however, only covers $900,000 of the total sum. This implies that investors must deposit $300,000 for the transaction to proceed. If these funds can be raised, the investors will ultimately own a $1,500,000 self-storage facility for a $300,000 initial investment.
Alternately, investors might utilize gap financing to cover a part of this $300,000 need, knowing that a portion of the refinancing profits could be used to reduce the deficit. This raises risk and interest expenditure, making it possible to manage this self-storage unit for substantially less than $300,000 in initial capital.
Step 6 of Self-Storage Financing: Project Cash Flows And Evaluate Investment Criteria
Investors have validated their operational pro forma, total contributed capital, and permanent mortgage debt service amounts at this step in the underwriting procedure. Next, they must set the exit conditions for the contract. Specifically, when will they sell the self-storage facility, and what investment requirements must be met? With this knowledge, investors may predict A) an exit capitalization rate (to inform market value upon sale) and B) property cash flow through the exit of the agreement.
Again, analytics companies can predict future capitalization rates, but we recommend a conservative estimate (that is, err on the side of awareness rather than accepting an inflated future exit price). To calculate cash flows, investors need to subtract debt payments and expected long-term capital improvements from predicted NOIs throughout the life of the investment.
With this information, investors may complete the last part of the underwriting procedure: deciding whether or not the statistics satisfy investment requirements. Internal rate of return (IRR) is a rational statistic for longer-term, value-added investments such as self-storage investments. Conceptually, IRR indicates the discount rate (technically, the interest rate) at which the present value of future cash inflows equals the initial cash outflow ($300,000). The IRR may be readily calculated by entering startup expenses, yearly cash flows, and the ultimate sales price into an Excel spreadsheet.
This is the truth in the underwriting process when investors decide if a deal’s financials meet their investment requirements. Assume, for instance, that this team’s self-storage investment hurdle rate for a five-year contract is 12 percent. If the estimated IRR is 15 percent, the transaction is acceptable and should be pursued. Conversely, an IRR of 8% shows that the returns do not justify the investment. When this occurs, investors may either A) negotiate a lower purchase price to improve their IRR or B) withdraw from the transaction.
Final Thoughts on Self-Storage Deal Analysis and Underwriting
Self-storage buildings might be intimidating for novice investors. Most of us have lived in apartment complexes, so we are familiar with multifamily homes. However, as seen above, the underwriting procedure for self-storage and multifamily transactions is comparable. Investing in self-storage facilities requires specific considerations, although the process of assessing offers does not alter considerably.
******************************
Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.