How to underwrite a self storage property? What does the bank want to see from you? Kathryn East has several years experience in the self storage industry, she is the Founder of Sopapta Consulting, Management & Auditing, and shares her knowledge.
How many self storage management styles are there?
There are three different management styles. You can get with a third party management company, big or small, and you would will still have to add that in the underwriting. You can go with a consulting firm that comes in, sets everything up, teaches you how to do it and then walks away after a time, then you are on your own to make sure it stays the way it should be. Or you can do what is called an unmanned property. Unmanned properties are not really unmanned, you still have to have a boots on the ground person. But it is significantly less expensive than doing a consulting fee, or doing a third party management company. In some of these smaller broker rooms, you won’t be able to apply a full time manager, because it’s outside of the 35% that you’re trying to underwrite the expenses for. If we are looking at it from an expense perspective, typically that is one of the first and largest expenses that you have.
When choosing management styles, we have to be careful to understand what is actually happening in that market with your true competitors. If every single competitor of yours has somebody in their office from 9 to 5, Monday through Saturday, you may have to do that as well, in order to keep yourself relevant in that market. We did try to do that in one market, fortunately, it worked out really well, and it was probably one of the toughest markets we’ve ever been in. It was one of the first markets I tried the unmanned style in, because every competitor that we had, had somebody in their office all the time. I thought “You’re spending a minimum of $30,000 a year for a full time employee to do what? To really stand there and just pick their nose”.
We did work through and tried that model, it was very successful. Now I am practically implementing that in every single facility that a client brings my way. That is always important to understand, because that will directly affect your underwriting. As you go to send those numbers to the bank, the bank wants to see that you have a clear operating formula, in order to make this place successful, you have got to be able to show the bank you can do what you say you’re going to do. The on demand management style is more well accepted now.
If I decided that I will do an unmanned facility, I will underwrite my true expenses. I have my “This is what is happening currently”, which generated my “This is what I can give you for your property”. Then I have my year one underwriting with value add, underwriting to a 35% expense ratio, and underwriting conservatively to those rate increases. I then have a third set. The third set is more realistic to the market. The good news is that when you are going to a bank, what they want to see are underwriting towards guidelines. With their guidelines, you can increase GPRI by up to a certain percentage in this market, which you can backup with data from StorTrack and other websites, you can backup the data that shows that your GPRI is going to be this. What you can’t do is backup data to show them that your expense ratio is going to be less than 35%. That is what they use as a norm.
That third set of books or numbers in this case, is going to be for you. You now have your worst case scenario, and now you have your best case scenario. You aren’t sending that one out to investors, or to anyone else. This is just what you believe you can do. When I go back to that broker's OM, and then go back to that broker, and I say “I’ve given you the price point that I would give, this is what I would give based on the numbers that you provided”. I give them an LOI, and said this is how much I’m going to give you. They will then come back with a counter offer, and I will use my second set of numbers, which is underwritten to the bank, so I know that I can add value by raising rates, adding tenant insurance, and other sources of add value income, but I still have that 35% expense ratio. Let’s say that the valued they wanted was $2.4M. I valued it at $1.7M based on their own numbers. But in my second set, I actually can go up to $2.1M. I am reaching my DSCR, which is my debt service coverage ratio of 1.25, maybe I have $400,000 that I have to invest based on 10 or 20% down, depending on what type of loan you’re going to apply for. I can do that myself, or if I have to have investors, my cash on cash return, and my IRR are working in my favor. That is how you underwrite a facility from a broker.
There are no bells or whistles, it literally is that easy. But you have to have the tools in which to do that, I have given some website names for the market, but you need to have what’s called a valuator, or a CRE model, which allows you to input the numbers, and work through your purchase to make sure that you have the right percentages before you hand it to a broker or bank. Some brokers will ask, where did you come up with this? So you have to be able to educate them, and show how you came up with this number based on what you told me, for instance, you are trying to sell it to me at 85% occupied, but your economic occupancy is 60%. I am not going to pay you for what you didn’t do with that facility. So we’re going to go with your 60% economic occupancy, which means it’s worth $1.7M, not $2.4.
What do they say when you when you go over that?
If it’s an experienced self storage broker, they will generally come back with “I absolutely understand what you are saying, however, this facility is not using the right kind of website, they’re not really promoting themselves very well. There’s delinquency that you could clear up”. Then your answer is "Okay, you said it right there for me, I have to do it. Why would I pay your client for what they did not do?". Or they will say “I’ve done a market research on this property, as you can see in my OM, based on my pro forma numbers in year one, and you could bring it to this value, which means it’ll actually exceed the purchase price in year one”. I will then say, Great, why didn’t you have your client do that? If you are going to sell this property at a price point that’s less than if you would have instructed that client to do what you state that they can do – why are you selling it? You're selling it short and ultimately affecting your client.
Obviously, they can project numbers, it’s like having a crystal ball in your hand. Sometimes that’s what it feels like when they're projecting exit strategies of three to five years from now. Do I know what cap rates or interest rates are going to be in three to five years? Of course not, all I know is this asset class is in a cycle. We were at the top of that cycle six months ago and now we’re going back down, and at some point we're going back up. After I have said to the broker “If you know it can do this, why not instruct your client to do that, and re-list it after six months of implementing your ideas that created this pro forma"? And they answer, Because they want to sell it now. Fair enough, then the now price is $1.7M.
Brokers are actually really nice, I have never felt disrespected or been disrespected by them. If they're not a self storage broker, your goal is not to offend them with your underwriting, it’s to educate them. It’s a give and take relationship when you are a buyer versus a seller. That’s what we’re looking at. I wish I could say that there is this long process about underwriting, and learning it does takes time, it might take you three hours to underwrite something to where you feel comfortable with writing an LOI, and that can take me 20 minutes, but I have been doing this for many years. I have perfected the way I am looking at it, but to be clear, I learn new things every single day about the underwriting process.
Broker OM's make it easier because they have done a lot of the legwork for you. Just reading that offering memorandum, looking at pictures, getting a good visual identity of what that property looks like currently, that’s all it’s about.
And this is just the beginning, you have more questions for the broker after you determine if this is a good project or not, the due diligence process, getting a loan, closing, managing and adding the value. This is the very first step.
Trust but verify, no matter how you are looking at it. Trust the broker that they did the legwork, that they have the right information, but always verify through your own systems as to whether or not it is actually true. The hard process is in the questions that you need to ask them, why are they selling, how motivated is that seller, what types of inspections and surveys can you provide that you have already done for the seller? They will say things like, we have an Alta Survey, a Phase I that they did when they bought the property, and you'll have to collect those things once they've accepted your LOI, even though you didn't start your due diligence period yet. If they say that they have it, go ahead and get it. That way, when you make your purchase agreement you'll have all these conditions and stipulations as to why you're offering this price, and this is how they're going to get it, by all of these items being true, to the best of their knowledge, and if not, the contingencies can kill the deal.
Or it's time to renegotiate.
There will be an automatic extension for certain contingencies, for example, if we can't get a Phase I in 30 days, we'll get an extension of 14 days. If we then need a Phase II report, that's an additional 6 weeks. I underwrite 45 days for due diligence and closing 45 days later, with a total of 90 days. That way I have time to get all my reports in, get the financing under control, and get the investors on board.
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