Finance • Section 16
in value experienced by an asset. If the debt in place is being serviced and does not expire, the equity erosion may only be a temporary situation that effectively creates a short-term paper loss with little consequence for the storage owner or lender. In situations where additional leverage is required, borrowers may have debt options available to suit their needs, as long as there is cash flow available to service debt.
Subordinate debt is a general term referring to any ad-
ditional financing with a lower priority to cash flow than the in-place first mortgage. This type of debt can provide more capital and higher leverage to help bridge an equity gap. Subordinate debt lenders in the current market will take a capital position between the first mortgage cut off, reaching up to 85 percent LTV–sometimes even higher.
By reaching higher in the capital stack, subordinate lend-
ers inherently assume greater risk and, therefore, get paid a higher interest rate or rate of return. Interest rates on sub- ordinate debt typically fall in the range of 10 to 20 percent, depending on the specific transaction. Subordinate debt lenders are often flexible and willing to structure payments to match the cash flow projections of the specific asset. For example, the debt might feature routine principal and inter- est payments to amortize down the balance. Otherwise, the payments might be structured as interest-only payments for several years before a balloon payment.
The two most common subordinate debt products are
junior mortgages (B-Notes) and mezzanine financing. Mez- zanine lenders provide subordinate debt that is secured against an ownership position in the borrowing entity rather than the mortgaged property itself. Conversely, B-Notes take a secondary debt position that is secured by the mortgaged property as collateral for the loan. This mortgage is junior in priority to the first mortgage or senior note (A-Note), hence the nomenclature.
There are situations where cash flow erosion is dramatic enough that the available cash from operations can no lon- ger support the debt service payments. In extreme cases, the corresponding value decline may be so severe that the spon- sor’s equity is completely eroded. In these situations, the sponsor may be required to infuse new equity into the trans- action. If the sponsor does not have the equity, this can be achieved through an equity joint venture. Joint venture eq- uity is typically available to commercial property owners in transactions where there is a significant upside to the transaction, often stemming from a development or re- capitalization scenario and resulting in enhanced cash flow and consequent value.
Capital Stack Example If property values experience a correction like the one that occurred in the aftermath of the Great Recession, it could be- come difficult for some storage owners to refinance out the entirety of their outstanding debt. If value deteriorates to the extent that available debt in the market is not sufficient to refinance what is owed, a self-storage owner might turn to mezzanine debt to fill the gap. What follows is a case study that could be very realistic in the event of a value correction.
Consider a self-storage portfolio that reported NOI of $2
million at the time of acquisition in 2016. If cap rates stood at approximately six percent, the portfolio would likely have qualified for loan proceeds of $25 million based on available LTV of 75 percent.
Next, assume that the new owner stabilized occupancy and grew NOI by a modest 10 percent in the ensuing five years. With a new NOI of $2.2 million, it seems the borrower has done a great job adding value and would be in a good position to refinance out of the existing debt.
Unfortunately, it isn’t always that simple. Cap rates are at
recent lows and values are accordingly very high. This is due in part to the fact that debt has been so inexpensive given low interest rates. Interest rates are finally on the rise and debt is becoming more expensive, which will put upward pressure on cap rates. In the example at hand, a 150-basis point increase in cap rates could cause a loan proceeds short- fall for this borrower. This could be the case, even considering the same available leverage point at 75 percent LTV and the increased cash flow highlighted above.
According to the calculations in the table below, this situ-
ation equates to a shortfall of roughly $960,000 (or $1 million including closing costs). This gap would need to be filled to refinance the transaction at the existing loan’s maturity. The property is not under water per se, as the value of $29.33 million still exceeds the balloon balance of approximately $22.96 million. However, mezzanine debt in the amount of $1 million would be required to bridge the gap and refinance the new loan. See Table 16.2 below.
This proceeds shortfall was primarily driven by an in-
crease in cap rates beyond the borrower’s control. In other words, while the borrower did exactly what a new buyer of
Origination $2,000,000 6.00% $33,333,333 75% $25,000,000 Current
$22,960,000
$2,200,000 7.50% $29,333,333 75% $22,000,000
2018 Self-Storage Almanac 167
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