There are many routes to obtain financing such as syndication, private equity and more. In this portion of our series, however, we are going to discuss conventional and SBA funding.
Until late 2010, most self-storage loans were funded conventionally. Conventional loans can be financed by your community bank or the local branch of one of the larger banks. The bank is going to focus mostly on your financial track record and dig into the details of how you will pay the loan back. They are going to be interested in the loan to value (LTV), as well as your net worth.
The lower the LTV, the less risk the bank takes in making the loan to you, and the more likely you will be approved for the loan. A lower LTV also means that you have more skin in the game and that you’re likely going to make sure that the loan does not default.
This is where many people fall short. Many people do not have the equity that banks need to feel that the loan is secure. Many banks are looking for 25-35 percent equity. For a $1M deal, this means you’ll need to have $250,000-$350,000 cash on hand. It’s also often the case that you’ll have to obtain working capital and interest to carry the project until it breaks even. Keep in mind that each bank will have different loan requirements.
A conventional loan will have a shorter term and you will likely need to refinance. Each time you refinance, there will be closing costs and expenses associated with doing so that you must pay. Typically, you will have financial and LTV covenants with a conventional loan, as well as debt service coverage ratio (DSCR) covenants that you must maintain or risk facing possible foreclosure. During the recession of the late 2000s, many loans were called because of LTV covenants.
The recession caused property values to drop in many areas around the country. Self-storage businesses that were doing well, making their payments and growing were surprised to receive calls or letters from their banks telling them that they were now out of LTV covenants because of the decrease in their property value. They were blindsided by the fact that they would now have to correct the offset in value by paying off part of the loan.
Banks may have loan covenants such as having a certain amount in your account or not allowing you to use your funds until you reach a particular milestone, which can be a pain for you as the borrower.
With a conventional loan, you will generally get a better interest rate because the bank is protecting themselves from any exposure. The problem? Many people only focus on the interest rate. They get accustomed to shopping for the best rate in their personal lives when it comes to things such as home mortgages and cars, but don’t necessarily understand that a business loan is entirely different.
The rate is only one part of the equation. What if you get a better rate with a specific lender, but they require that you put down more money than you have or are comfortable with putting down? What if you can get the loan, but not the amount of working capital and interest-only payments that you need to get to a point where the project can pay for itself without you having to feed it every month? These are just a few things to consider.
Prepayment penalties can vary, but most are five years and drop each year. For example, if you prepay in the first five years, the prepayment penalty is five percent the first year, four percent the second year, three percent the third year and so on.
Like any loan, conventional loans have their pros and cons, and it’s important to weigh them when looking at your self-storage financing options.
SBA lending: 7(a)
The SBA has two different loan programs: The 7(a) and 504 programs. The 7(a)–in our opinion–is the best option for a new construction project, but is also a viable program when it comes to business acquisitions.
The 7(a) loan is a cash flow-based loan. It is based mostly on the ability of the project to pay for itself, rather than being solely based on your net worth or the LTV of the project.
The SBA does not make the loan, nor is the SBA’s money used to fund it. The bank lends its money, and the SBA guarantees part of the loan against any losses the bank might suffer if the loan defaults.
The minimum equity requirement is only 10 percent. Compared to the equity requirements that many conventional loans require, the 7(a) program is more flexible for the borrower.
If we use the same $1M example as we did earlier in the post, the required equity might only be $100,000 vs. that original equity number of $250,000-$350,000. This makes a big difference, especially for those borrowers who do not have that much cash on hand.
Suppose that you do have the equity it takes to get a conventional loan. Obtaining it, however, will drain most of your savings. Do you want to put all your chips on the table at one time, or would you rather have some set aside in case you need them down the road?
There are no financial covenants for a 7(a) loan, besides the requirement that you must make your loan payment each month. The only way you can have your loan called is if you fail to make your payments.
An SBA loan is typically a 25-year, fully-amortizing loan, which means that you never have to refinance. What does this mean for you? It means that you will not have to cover the extra expenses for closing costs and other costs that are typically associated with a refinance.
Working capital and carrying costs can usually be included to get the project to the breakeven point. If you are taking over a project that needs updates and repairs–or if you are expanding your self-storage facility–working capital can help to cover these costs.
There is a $5M cap on the 7(a) program, but Live Oak can potentially add up to nearly $5M of conventional funds to help get borrowers where they need to be and ensure a successful project. At Live Oak, we have programs we can take advantage of in addition to SBA 7(a) and conventional funding to finance larger amounts.
Prepayment penalties for SBA 7(a) loans are three years, but you can prepay up to 25 percent per year without a penalty. The penalty amounts are three percent for the first year, three percent for the second year and one percent for the third year.
There are no origination fees, but there is an SBA fee associated with the 7(a) loan program. This program is not funded by taxpayers, so each borrower pays an SBA fee that is rolled into the loan. There is a formula for how this fee is calculated, but it roughly equals two to three percent of the total loan amount.
SBA lending: 504
Below is a breakdown of how the 504 is funded:
- 50 percent of the loan is funded by financial institution (the bank)
- 35-40 percent of the loan is financed by the SBA with the assistance of a CDC
- 10-15 percent of the loan is funded by borrowers’ equity
It can take longer for a 504 loan to close because a minimum of three entities have to review and approve it. These three entities include the bank, the SBA and the CDC. The CDC is a liaison that facilitates the loan with the SBA and the bank. Sometimes there is an additional bank that is involved to limit the exposure of the first bank. This is usually used for larger projects or projects that involve construction.
A 504 loan requires a minimum of 10 percent equity for an expansion. If it’s a new business, the minimum equity requirement is 15 percent. Therefore, if the project involves a new business, you’d have to bring 50 percent more equity to the table than you would have to with a 7(a) loan.
The prepayment with the 504 loan is 10 years for the SBA portion, which is fixed for 20 years (optional 25-year term). The bank’s portion can be either fixed or variable.
If you have any questions about the self-storage acquisition process or about your financing options, please free to contact our lending team. You can find out more about our team and get their contact information at www.liveoakbank.com/selfstorage. For additional information, please check out our other self-storage resources or access our Knowledge Bank.