I’ve hired 30 employees outside of the USA with the help of Shepherd and it has been an absolute game changer for my business.
Underwriters in Colombia for $1,500 per month full time. Customer service reps with perfect english in the Philippines for $1,100 per month. Executive assistants for my construction team for $1,000 per month.
If you haven’t hired an employee abroad, doing so will change your business and your life. I recommend setting up a call with Shepherd and getting the process started.
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Self storage acquisitions have been BRUTAL the past 8 months.
We have 3 full time cold callers making 300+ dials a week. Direct mail. Email campaigns. 30+ broker lists showing us 50+ deals a month.
My team of 8 working full time. In that time period we’ve gotten 1 deal under contract at $1.2 million.
Sellers simply aren’t willing to let properties go for less than 2021 highs despite borrowing rates being 4% higher (from 3.5% in 2021 to 7.5% now).
There is no distress yet in storage and every owner was aware of the run up in values in 2021 because they got pounded by brokers…
Why would they let their properties go for less right now? Unless they NEED to sell they wouldn’t, and they aren’t. They’re happy to sit on their cash-flowing self storage properties and continue running their healthy businesses.
When will the distress hit commercial real estate?
I have no idea.
If an investor predicts anything with certainty, they aren’t a good investor. My job is to prepare for the most common possible outcomes and protect risks in the event of serious pain.
Commercial real estate pain hits when loans mature and values are lower or rates are higher…
And it is a slow-motion train wreck that takes years to play out. And it lags the economy significantly beacuse of just how long real estate distress takes to bubble to the surface and happen.
Here’s how it works:
Unlike residential real estate with 30 year loans with fixed rate, the majority of commercial real estate utilizes 3-5 year debt, often with floating rates.
3 year debt is called “bridge” debt and it is utilized by folks with a construction project or a value add plan. They have work to do on a property and they plan to replace the debt with more permanent debt when the work is done and the property is finished or has more profit (net operating income).
We utilized bridge debt in 2021 when we were acquiring severely mismanaged and under-performing properties. It was floating rate and sat at 3.85% for a long time. Then in 2022 it began creeping up and we ended up locking it all in at 5.85% or so.
On $40 million of debt, that is an $800k annual hit to cashflow, most of which was our promote (or the additional profit on top of a preferred return we owed to investors).
The drop in cashflow is a problem, but the real problem comes when the 3 year bridge debt or 5 year standard debt expires and the bank wants you to refinance and repay their loans.
In most economic situations that is no problem. Banks are eager to lend and debt is similarly priced, so you just go out and refinance with another bank.
But when debt is SIGNIFICANTLY more expensive like it is now and properties are generating less income like they are now, the debt becomes impossible to replace at a new bank.
Here’s the math behind it:
You bought a property for $1 million with $700k from a bank at 3.5% on a 3 year term, all interest-only (meaning no amortization or repayment of principal).
The property was generating $65,000 of NOI (profit).
The total cost of the debt with the 3.5% interest and no amortization (paying back principal) is 3.5% of the loan amount, or $24,500 per year.
You have $65,000 in NOI, of which you use $24,500 to pay debt service, and you’re left with $40,500 of annual cashflow. That represents a 13.5% cash-on-cash return on your $300k invested. A home run!
But not so fast. This is where the trouble starts…
Let’s say you haven’t been able to increase NOI on your storage property because less homes are selling (this is true, my portfolio is about 73% occupancy vs 80% at this time last year).
And now it’s time to replace your debt at the end of your 3 year term. You still have $65,000 of NOI supporting $700,000 of debt.
Literally NOTHING has changed about the operation of your business. Still healthy. Still generating $65k in profit.
But we’re in a totally new economic environment today. Bank deposits are down because of the SVB debacle and lending branches are tightening up. They’re way less likely to lend and debt is harder to get. Banks are turning you down. You don’t have any option to get an “interest only” loan.
You finally find a bank willing to loan but new debt terms come back at 7.75% interest. So you’re paying about 10% of the total loan amount when you add in amortization on a 25 year term.
This 10% is called a “debt constant” and it’s a very important figure for us to understand when it comes to risk. For more on the debt constant and this topic, take my free mini-course to see how debt and NOI are related and how the risk works.
The debt service on your $700k loan would be $70,000 per year. But you only make $65,000 in NOI.
The bank wisely declines your request for $700,000 to replace your previous loan.
“No way we’ll loan you more money than the property can afford to pay for.”
They’ll only lend you enough money to cover your debt by 1.25x. Meaning pre-debt cashflow from the property needs to be 25% greater than the payment each month.
You can see already this is spelling trouble but lets keep going.
The property can afford to pay $52,000 annually for debt service to meet the 1.25x debt service coverage ratio (DSCR).
So how much can we borrow if our debt costs us 10% annually with principal repayments?
$520,000.
The banks will now, 3 years after your initial loan, only loan you $520,000 but you currently have $700,000 in debt.
Big trouble. You have three options:
- Go out and raise $180,000 from your initial investors (this is called a “capital call” and nobody likes them)
- Put in $180,000 of your own cash if you’re lucky enough to have it laying around.
- Go back to your bank and beg for mercy.
- Sell your property at a loss for $700k when you paid $1 million just to pay off your loan and walk away.
#3 or #4 is the more likely scenario because most real estate investors don’t keep enough cash on hand.
They don’t want to sell at a loss so first they go to the bank and say “I can’t pay, work with me or you can take my keys and deed to this property.”
But the bank doesn’t want the keys. They don’t want to operate a self storage facility. The business will likely fail while they own it and that $65k of NOI will start to go down, making it worth even less.
So the banks work with the owners as much as possible. This process takes months. They try to give them some flexibility or maybe extend the term of the loan.
Eventually they foreclose on the loan and take back the property or the owner runs out of money to make payments at all and they end up selling at a loss. Equity gone. Cash gone.
A lot of investors also personally guarantee debt. So if the bank can only sell the property for $600k but the loan was $700k, they go after the owner for that last $100k.
But the owner has been in a financial pickle for months and doesn’t have the cash. So they go to court and take ownership of the real estate investors home and bank accounts.
Bankruptcy ensues.
Investors in the properties lose everything.
This process is what happened to 90% of the folks who went bankrupt in the 2008 crisis. It wasn’t lack of cashflow. It wasn’t the fundamentals of the business changing…
It was the loan maturing…
Here is the thing about this situation:
Because banks don’t want to take back properties and loans are on 3 and 5 year term (mostly 5) it takes a REALLY LONG TIME for this to all go down.
That is why there is such a lag in the market. Debt is more expensive but property owners are holding on because they don’t want to lock in losses. They’re working with investors on capital calls. They’re working with banks to extend loans.
They’re doing everything possible to NOT take a loss and sell at a discount.
And then there is an entirely other section (the majority) of the population who owns real estate without loans. They are 50+ and have been operating a self storage facility for 20 years. It prints cash and they don’t like risk so they dont’ have any debt on the property.
Values are starting to plummet so they have absolutely no desire to sell for less than they could have sold for a few years ago.
So the market freezes up. Only a few transactions for very motivated sellers (with expiring debt, a death in the family, etc).
And here we are. Waiting for the dominos to fall and waiting to see what happens. And doing virtually no deals.
How am I keeping my acquisitions team motivated?
Simply put, I haven’t been able to. We’ve lost 4 of the cold callers over the past year. They quit or were let go to chase other opportunities.
We know this goes in phases and the buying opportunities will come back. It is cyclical. We’ll ride out a few tough years here and then the volume will pick up. The great acquisition teams know that and it’s the message we’re spreading to our team.
What is our plan?
Our company is a sleeping giant ready to wake up and buy a lot of storage.
2021 was a very stressful year. We went from 6 employees at the beginning of the year to 40 employees at the end and we acquired $50 million worth of storage across 38 properties.
Many of the properties were severely mismanaged and needed a lot of capital improvements.
We built the team to execute these renovations and value-adds. We began leasing units. It was an incredibly stressful time.
2022 was the year of processes for us. We got better at renting units. We got better at closing deals. Underwriting. Renovating. Collections. You name it.
Now we’re sitting on our hands…
But we’re prepared. Our team is ready and waiting to have a breakout year as soon as opportunities come. We have the systems to buy a TON of storage all at once. We could have a $100 million acquisition year and it wouldn’t be as stressful as 2021 and we’d do a better job.
So now we be patient and keep hammering the phones. We keep underwriting deals. Our team of 8 in the acquisitions branch of our business is working hard and the fruit will come.
Onward and upward,
Nick