Navigating Real Estate Debt Challenges in the Self Storage Market

The availability of real estate debt has become a major headwind impacting the industry. Many real estate developers encounter difficulties when attempting to secure construction debt from banks. What is at the root of the concern, and how is the self storage industry performance positioned for this financial climate?

THE CHALLENGES OF SECURING CONSTRUCTION DEBT

Securing construction debt has become an arduous task for real estate developers. Traditionally, developers have relied on banks for their deep understanding of local markets and their ability to assess risk effectively. However, the landscape has drastically changed, with most major banks refraining from lending altogether.

Furthermore, the failures of some regional banks have sent ripples of concern throughout the industry, leading to a scarcity of lending options. Even smaller local community banks, which might have not have been overextended in real estate or faced issues with their bond portfolios, are not readily offering commercial real estate loans.

Finding a bank that is willing to provide debt for a commercial real estate project in the desired market, at reasonable terms, has become more challenging than ever before, with loan-to-cost ratios of around 60-65% being increasingly difficult to obtain. In the aftermath of the Great Financial Crisis (GFC), the availability of debt was a major concern, but options were still accessible. Today, we find ourselves engaging with numerous banks, scouring for one suitable lender willing to provide the necessary debt for DXD Capital.

REAL ESTATE DEBT: AN INTEREST RATE OR STRUCTURAL CONCERN?

The significance of debt in real estate projects has become increasingly evident, prompting even sophisticated investors to prioritize securing debt before investment. Just a year ago, an equity partner's primary question may not have revolved around debt, but now it holds the utmost importance. No investor wants to commit equity before the debt is secured.

The changing landscape has given rise to concerns about interest rates and structural aspects of the financing. It is now crucial to evaluate potential projects meticulously, considering the impact of more stringent underwriting, reduced loan-to-cost ratios, and higher interest rates.

In the past, when rates were exceptionally low, reaching loan-to-cost ratios of 65-70% and securing 4% interest rates, many deals appeared attractive. However, with the current environment offering loan-to-cost ratios as low as 55% and interest rates of 8%, the appeal of such deals diminishes. As a result, it is likely that numerous deals that would have transpired two to three years ago will be shelved due to the unavailability of debt and returns that fail to attract capital.

IS SELF STORAGE PERFORMANCE BETTER POSITIONED CONSIDERING THIS INFORMATION OR WORSE?

While self storage faces similar challenges to other real estate investment classes, such as rising construction costs and higher debt expenses, it presents unique opportunities that make it an appealing investment option. Self storage deals continue to offer attractive margins, with many projects generating mid-7% to low-8% going-in cap rates, ensuring profitable outcomes for investors.

Self storage investments possess fundamental attributes that make them attractive real estate opportunities:

1. ABILITY TO TRACK INFLATION

Self storage employs dynamic rates, allowing for aggressive rent increases when market shifts demand it. With month-to-month leases, DXD Capital maintains the flexibility to adjust rental rates in response to inflationary pressures.

2. STABLE OCCUPANCY

Once self storage properties reach occupancy, they tend to maintain stability. Unlike hotels or multifamily properties that may experience drastic drops in occupancy, self storage facilities typically reach a point of equilibrium where tenants are less likely to vacate and seek cheaper alternatives.

3. LIMITED VULNERABILITY

The primary vulnerability in self storage lies in competition during the initial lease-up period. However, once a facility reaches full occupancy, this vulnerability diminishes significantly, providing investors with greater stability.

The challenging landscape of the real estate market, particularly in securing construction debt, poses significant obstacles for developers. However, amidst these hurdles, self storage investments stand out as a promising option, offering attractive returns and unique advantages such as the ability to track inflation, stable occupancy, and limited vulnerability.