Seller financing for self storage: structures, terms and the math

Two structures: seller note alone vs seller second

The seller carries the whole loan

On a smaller facility, especially one the seller owns free and clear, the seller can act as the only lender. You pay a down payment, the seller records a first lien, and you pay the seller directly. There is no bank underwriting, no appraisal requirement unless you ask for one, and the terms are whatever you negotiate. That flexibility cuts both ways. Nobody else is checking whether the price and the debt make sense, so you have to.

If the seller still has a mortgage, find out early. Their loan may not allow the property to be sold or further encumbered without the lender's approval. That is a question for the seller's lender and both parties' attorneys, not something to work around.

Sellers often agree to carry paper for tax reasons. Under the IRS installment method, a seller includes in income each year only the part of the gain received that year. The IRS also says that any gain that is ordinary income under the depreciation recapture rules must be reported in the year of sale. A seller who has depreciated a facility for years may owe tax at closing even on a mostly seller-financed sale, so the down payment you offer needs to cover that bill. The seller's CPA should run the numbers.

The seller takes a second behind a bank loan

The other structure pairs a bank first mortgage with a seller second, for example 65% from the bank, 10% from the seller and 25% from you. The bank holds the first lien, and the seller note is subordinate. Three things decide whether it works:

• Lender consent. Commercial loan documents commonly restrict additional debt or liens on the property. SBA's own rules show how routine these clauses are: a bank participating in a 504 loan waives any provision prohibiting further encumbrances as to the CDC financing (13 CFR 120.921). Ask your lender in writing whether it allows a seller second, whether it may be secured, and on what terms. Some senior lenders restrict secondary financing altogether. On a nonrecourse loan the stakes are higher: the OCC notes that guarantees on nonrecourse loans usually carry carve-outs for “bad acts” that include unapproved liens and prohibited transfers, and some carve-outs make the loan full recourse. A seller lien recorded without the senior lender's approval could put you personally on the hook for the whole loan. Where extra debt is allowed, it may have to take the form of mezzanine debt, which the CRE Finance Council defines as a subordinate loan secured by an ownership interest in the borrower rather than by the property itself.
• Subordination and standby. Expect the bank to require a subordination or intercreditor agreement that limits the seller's ability to accelerate, foreclose or collect after a default. A standby agreement goes further and suspends payments on the seller note. For SBA 7(a) loans, only debt on full standby (no principal or interest payments for the term of the SBA loan) can count as equity. In a 504 project, seller financing must be subordinate to the 504 loan (13 CFR 120.923).
• Combined coverage. A lender may size the first mortgage on its own DSCR and still check DSCR on both notes combined. A structure that passes on the bank loan alone can fail once the seller payment is added.

Terms to negotiate

No published source gives reliable “typical” seller-note terms for self storage, and any number you hear secondhand reflects one deal and one seller. Treat each of these as a lever and model the effect of each before you offer:

• Rate. The seller's CPA will want it high enough to avoid imputed-interest problems. You want it low enough that the note helps your cash flow.
• Amortization. A longer schedule lowers the payment and the note's loan constant, which matters more to cash-on-cash than the rate alone.
• Interest-only period. Interest-only payments during lease-up or a value-add program can keep combined DSCR above the bank's floor while NOI grows.
• Balloon. When the remaining balance is due, and whether that date is before, with or after the bank loan matures. Two balloons in the same year are one large refinance problem.
• Prepayment. Whether you can pay the note off early without penalty, for example when you refinance after stabilization.
• Security and guarantees. A recorded second lien, a pledge of LLC interests, a personal guarantee or none. Each changes what the seller can do if you default.
• Default and cure. Notice periods, cure rights and whether a bank default automatically defaults the seller note.
• Offset rights. The right to reduce note payments if the seller's representations about the rent roll, taxes or environmental condition turn out to be wrong. Sellers resist this, but it turns the note into a holdback.

How a seller second changes equity, DSCR and cash-on-cash

Three formulas cover it:

The seller note swaps equity for debt service. Whether that swap raises cash-on-cash has a simple test. Compute the note's loan constant (its annual payment divided by its balance) and compare it with the cash-on-cash you would earn without the note. If the constant is lower, the note raises cash-on-cash. If it is higher, the note lowers cash-on-cash even though you put in less money. A note that fully amortizes over a short period can have a high constant even at a modest rate.

Worked example: $3.5 million purchase with a seller second

Suppose you are buying a stabilized facility for $3,500,000 with NOI of $262,500, a 7.5% cap rate. The bank lends 65% ($2,275,000) at 7.0% on a 25-year amortization. The seller carries $350,000 (10%) at 6.0% on a 20-year amortization with a seven-year balloon. All terms are hypothetical, and equity is shown before closing costs.

The seller note saves you $350,000 of equity, but combined DSCR drops from 1.36x to 1.18x, which would fail a lender that tests combined coverage at 1.25x. Cash-on-cash also falls, from 5.68% to 4.51%. The note's loan constant is 8.60% ($30,090 ÷ $350,000), well above the 5.68% you earn without it, so every dollar it replaces costs more than it saves. Risk rises too. Without the note, NOI can fall 26.5% before the bank loan alone reaches 1.00x. With the note, a 15.0% drop brings combined coverage to 1.00x.

Same $350,000, different terms

Only the 5.0% interest-only note and the standby note have constants below 5.68%, so only they raise cash-on-cash. Watch the rounding as well: the 5.0% interest-only case is 1.247x, which rounds to 1.25x but fails a strict 1.25x test. These are cash measures. An amortizing seller note also pays down principal, and after seven years of payments the balloon on the 20-year note is about $271,000. That paydown shows up in your IRR and equity multiple, not in cash-on-cash.

Risks for both sides

For the buyer

• Refinance risk. A seller balloon that comes due before NOI has grown, or in the same year as the bank maturity, forces a refinance on the market's terms.
• Thin coverage. Combined DSCR near 1.20x leaves little room for a rate reset, a tax reassessment or a street-rate drop. Stress-test with break-even occupancy.
• Cross-default. A default on either note may trigger the other. Read both sets of documents together.
• The seller stays involved. A seller-creditor has a financial reason to watch how you run the facility and a legal position if you miss payments.
• Lower cash yield. As the example shows, a high-constant note can lower cash-on-cash while it raises risk.

For the seller

• Subordinate position. Behind a bank, the seller is paid only after the senior loan and may recover little in a foreclosure. The CRE Finance Council defines a subordinate lien as one whose rights to the collateral are junior to another debt.
• Standby means no cash. Under a full standby, the seller receives nothing until the senior loan is repaid, possibly for decades.
• Buyer execution. The seller's return depends on a new operator. Sellers should ask for the buyer's financial statements, experience and business plan, just as a bank would.
• Tax timing. Depreciation recapture can be taxed in the year of sale even when most of the price arrives later, per the IRS installment-sale rules.

Seller financing is a negotiated contract with legal and tax consequences on both sides. Confirm the senior lender's position in writing, and have each party's attorney and CPA review the note, the security documents and any subordination agreement before signing. For how the senior loan is sized, see self storage loans. For SBA-specific rules, see SBA loans for self storage.

This guide is general education about self-storage underwriting, not investment, lending, tax or legal advice. Figures from third-party reports are cited with their dates and change over time.