How is your lending expertise when it comes to self-storage loans? Since the lending sector is risky compared to other traditional bank lending lines, it pays to understand not only the drivers of risk, but now since the rise of data analytics, what factors help tip the probabilities of success in your favor. This article highlights a continued trend in banking of how lenders can take a sector with a higher than average risk, and through better underwriting, monitoring and management, can reduce their risk in almost half. This article will present an update on the status of risk for the sector and the drivers of lending performance culled by a review of more than 1,200 loans to self-storage units across the country over the past ten years.
Self-storage lending is having a good run as the average property level cash flow is up 8% from January to April of this year, the most of any of the “Other” category on bank’s balance sheets to include mobile home parks, healthcare, coop housing and other specialty property. Demand is getting back to pre-recession levels and supply is now starting to lag. Probabilities of defaults are down from their near term highs of 4.6% and are now approximately 2.3%. As cap rates continue to come down (currently in the 9% to 11% range), valuations are increasing and loss given defaults are now back down to below 30% for the first time since 2007. On a forward risk adjusted return basis, the risk/reward profile is similar to the market in 2004.
The nuance to self-storage lending is the fact that almost 85% of the expenses are fixed. The self-storage business is highly fragmented and largely dominated by small players that often focus on optimizing physical occupancy instead of net income. Since most costs are fixed, so maximizing revenues while holding expenses in line creates profit and adds value.
Because of high percentage of fixed costs, economics are largely preordained from the start which makes picking the right project to finance more important. Lenders know well how to look for the basics of cost per unit of expected revenue and to make sure both projected property and global cash flows are realistic, but there are a variety of other factors which the data points to, that lenders may not know.
Why Location Matters
The old real estate adage of “location, location, location” is never truer than with self-storage. The number one predictor of self-storage loan performance is area traffic around the subject property. This is a factor that is often overlooked as many independent operators convince their banks that cheaper property costs are better than location. The data argues against this notion as properties around major corridors have higher cash flow. Given that nearly 30% of customers find a property by driving by it (the internet makes up 50%) and more than half of customers make the choice of self-storage based on location, not price, location is key. Find a property to finance where traffic counts exceed 20,000 per day, and the probability of default drops by almost half.
Next to traffic flow, high population and business densities tend to be accurate predictors of cash flow success. The average self-storage customer base is composed of 30% commercial and 70% residential customers. Thus, high traffic areas next to dense residential areas with both houses and apartments are ideal. Residential customers that are moving into our out of the area compose almost 50% of the customer base, while 30% comes from apartments and 13% from townhouses and condos. Because of this fact, having self-storage properties in areas where population density exceeds 1,000 households per square mile portends positive loan performance.
As a side note, while we tried to look at the data for competition and units available per density, because competition is dynamic, it is difficult to isolate loan performance given competition. However, the presence of competition is usually a positive indicator to performance, as competition usually arises in lucrative areas. Thus, while competition may hurt pricing power, it is also likely positively correlated to performance as a result of attributes of physical location.
Facilities that are over 35,000 square feet and 50,000 square feet are two statistical stratifications where loan defaults decrease as larger properties tend to be more stable in terms of cash flow volatility (likely due to larger marketing budgets). Smaller properties tend to be more risky and thus should be priced and structured accordingly.
Next to being able to purchase and develop suitable real estate, experience matters as those operators with five or more properties and five or more years of experience tend to do better than first or second time operators. The ability to offer climate controlled units, a effort to market to businesses, the development of ancillary income associated with selling moving supplies, door alarms, premium service, insurance or similar also help property economics.
Management that is proactive in rate increases and decreases is also key to have a successful property. Those properties that do not dynamically adjust rates tend to lack cash flow performance compared to national averages. For example, apartment rents are up an average of 3.4% since the start of the year, or the strongest bump in the last five years. Storage management that has increased rates this year has found demand relatively inelastic and cash flow increased. Verifying that management has a history of revenue management is a marker for better than average performance.
Given that loan pricing is still greater than Prime + 1% for quality self-storage financing and the risks have dramatically decreased this year, self-storage presents an enticing lending opportunity to community banks. However, because probabilities of defaults are typically above those of multi-family, retail, office, hospitality and other traditional lines of lending, making sure your properties are located along major thoroughfares, making sure the area has ample household/business density and making sure management has both the experience and the orientation to proactively optimize net income and you can find your bank with a self-storage loan portfolio that performs better than average.
Submitted by Chris Nichols on June 09, 2014