4. FAIR VALUE OF FINANCIAL INSTRUMENTS

The fair value option under ASC 825-10 allows companies to elect to report selected financial assets and liabilities at fair value. The Company has elected the fair value option of accounting for its development property investments, bridge loan investments and operating property loan investments in order to provide stockholders and others who rely on the Company’s financial statements with a more complete and accurate understanding of the Company’s economic performance, including its revenues and value inherent in its equity participation in self-storage development projects.

The Company applies ASC 820, Fair Value Measurement (“ASC 820”), which defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosure of fair value measurements. ASC 820 defines fair value as the price that would be received for an investment in an orderly transaction between market participants on the measurement date. ASC 820 requires the Company to assume that the investment is sold in its principal market to market participants or, in the absence of a principal market, the most advantageous market, which may be a hypothetical market. Market participants are defined as buyers and sellers in the principal or most advantageous market that are independent, knowledgeable, and willing and able to transact. In accordance with ASC 820, the Company considers its principal market as the market for the purchase and sale of self-storage properties, which the Company believes would be the most likely market for the Company’s loan and equity investments given the nature of the collateral securing such loans and the types of borrowers. ASC 820 specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. In accordance with ASC 820, these inputs are summarized in the three broad levels listed below:



Level 1-	Quoted prices for identical assets or liabilities in an active market.

Level 2-	Financial assets and liabilities whose values are based on the following: (i) Quoted prices for similar assets or liabilities in active markets; (ii) Quoted prices for identical or similar assets or liabilities in non-active markets; (iii) Pricing models whose inputs are derived principally from or corroborated by observable market data for substantially the full term of the asset or liability.

Level 3-	Prices or valuation techniques based on inputs that are both unobservable and significant to the overall fair value measurement.

The carrying values of cash, other loans, receivables, the secured revolving credit facility, senior loan participations and payables approximate their fair values due to their short-term nature or due to a variable interest rate. Cash, receivables, and payables are categorized as Level 1 instruments in the measurement of fair value. Other loans, the secured revolving credit facility and senior loan participations are categorized as Level 2 instruments in the measurement of fair value as the fair values of these investments are determined using a discounted cash flow model with inputs from third-party pricing sources and similar instruments. The following table summarizes the instruments categorized in Level 3 of the fair value hierarchy and the valuation techniques and inputs used to measure their fair value.



Instrument	Valuation technique and assumptions	Hierarchy classification

Development property investments	Valuations are determined using an Income Approach analysis, using the discounted cash flow method model, capturing the prepayment penalty / call price schedule as applicable. The valuation models are calibrated to the total investment net drawn amount as of the issuance date.	Level 3

Development property investments with a profits interest and bridge loan investments (a)	Valuations are determined using an Income Approach analysis, using the discounted cash flow method model, capturing the prepayment penalty / call price schedule as applicable. The valuation models are calibrated to the total investment net drawn amount as of the issuance date factoring in the value of the Profits Interests. Typically, the calibration is done on an investment level basis. In certain instances, we may acquire a portfolio of investments in which case the calibration is done on an aggregate basis to the aggregate net drawn amount as of the date of issuance.	Level 3

	An option-pricing method (OPM) framework is utilized to calculate the value of the Profits Interests. At certain stages in the investments life cycle (as described subsequently), the OPM requires an enterprise value derived from fair value of the underlying real estate project. The fair value of the underlying real estate project is determined using either a discounted cash flows model or direct capitalization approach.

Operating property loans	Valuations are determined using an Income Approach analysis, using the discounted cash flow method model, capturing the prepayment penalty / call price schedule as applicable.	Level 3


(a)	Certain of the Company's development property investments include Profits Interests.

The Company’s development property investments, bridge loan investments and operating property loan investments are valued using two different valuation techniques. The first valuation technique is an income approach analysis of the debt instrument components of the Company’s investments. The second valuation technique is an option pricing model (“OPM”) that is used to determine the fair value of any Profits Interests associated with an investment. The valuation models are calibrated to the total investment net drawn amount as of the issuance date factoring in the value of the Profits Interests. At the issuance date of each development property investment, generally the value of the property underlying such investment approximates the sum of the net investment drawn amount plus the developer’s equity investment. Typically the calibration is done on an investment level basis. To the extent investments are entered into on a portfolio basis, the valuation models are calibrated on an aggregate basis to the aggregate net investment proceeds using the overall implied internal rate of return using a discounted cash flow for each investment.

For development property investments with a Profits Interest, at a certain stage of construction, the OPM incorporates an adjustment to measure entrepreneurial profit. Entrepreneurial profit is a monetary return above total construction costs that provides compensation for the risk of a development project. Under this method, the value of each property is estimated based on the cost incurred to date, plus an estimated earned entrepreneurial profit. Total entrepreneurial profit is estimated as the difference between the projected value of a property at stabilization and the total development costs, including land, building improvements, and lease-up costs. Utilizing information obtained from the market coupled with the Company’s own experience, the Company has estimated that in most cases, approximately one-third of the entrepreneurial profit is earned during the construction period beginning when construction is approximately 40% complete and ending when construction is substantially complete, and approximately two-thirds of the entrepreneurial profit is earned when construction is substantially complete through stabilization. For the thirteen development property investments that were 40% complete but for which construction was not substantially complete at June 30, 2018, the Company has estimated the entrepreneurial profit adjustment to the enterprise value input used in the option pricing model to be equal to one-third of the estimated entrepreneurial profit, allocated on a straight-line basis. Eighteen development property and bridge loan investments, not including the properties reported as self-storage real estate owned, had reached substantial construction completion and/or received a certificate of occupancy at June 30, 2018. For the Company’s development property and bridge loan investments at substantial construction completion, a discounted cash flow model, based on periodically updated estimates of rental rates, occupancy and operating expenses, is the primary method for projecting value of a project. The Company also will consider inputs such as appraisals which differ from the developer’s equity investment, bona fide third-party offers to purchase development projects, sales of development projects, or sales of comparable properties in its markets.

Level 3 Fair Value Measurements

The following tables summarize the significant unobservable inputs the Company used to value its investments categorized within Level 3 as of June 30, 2018 and December 31, 2017. These tables are not intended to be all-inclusive, but instead to capture the significant unobservable inputs relevant to the Company’s determination of fair values.



As of June 30, 2018
		Unobservable Inputs
	Primary Valuation			Weighted
Asset Category	Techniques	Input	Estimated Range	Average

Development property investments and bridge loan investments (a)	Income approach analysis	Market yields/discount rate	4.81 - 12.25%	9.24%
		Exit date (d)	0.25 - 6.46 years	3.54 years

Development property investments with a profits interest and bridge loan investments (b)	Option pricing model	Volatility	51.74 - 92.34%	72.35%
		Exit date (d)	0.25 - 6.46 years	3.68 years
		Capitalization rate (c)	5.25 - 6.15%	5.48%
		Discount rate (c)	8.25 - 11.20%	8.85%

Operating property loans	Income approach analysis	Market yields/discount rate	6.47 - 7.43%	6.87%
		Exit date (d)	3.48 - 4.15 years	3.87 years


(a)	The valuation technique for the development property investments with a Profits Interest does not differ from the development property investments without a Profits Interest. Therefore, this line item focuses on all development property investments, including those with a Profits Interest.
(b)	The valuation technique for the development property investments with a Profits Interest does not differ from the development property investments without a Profits Interest. The development property investments with a Profits Interest only require incremental valuation techniques to determine the value of the Profits Interest. Therefore this line only focuses on the Profits Interest valuation.
(c)	Thirty-one properties were 40% - 100% complete, thus requiring a capitalization rate and/or discount rate to derive entrepreneurial profit which are used to derive the enterprise value input to the OPM. Capitalization rates are estimated based on current data derived from independent sources in the markets in which the Company holds investments.
(d)	The exit dates for the development property investments and bridge loan investments are generally the estimated date of stabilization of the underlying property. The exit dates for the operating property loans are the contractual maturity dates.



As of December 31, 2017
		Unobservable Inputs
	Primary Valuation			Weighted
Asset Category	Techniques	Input	Estimated Range	Average

Development property investments (a)	Income approach analysis	Market yields/discount rate	7.83 - 10.62%	9.00%
		Exit date (d)	0.08 - 6.71 years	2.96

Development property investments with a profits interest (b)	Option pricing model	Volatility	63.94 - 94.03%	74.08%
		Exit date (d)	0.42 - 6.71 years	3.12 years
		Capitalization rate (c)	5.50 - 6.15%	5.51%
		Discount rate (c)	8.50 - 9.15%	8.51%

Operating property loans	Income approach analysis	Market yields/discount rate	6.08 - 7.01%	6.47%
		Exit date (d)	3.98 - 4.65 years	4.37 years


(a)	The valuation technique for the development property investments with a Profits Interest does not differ from the development property investments without a Profits Interest. Therefore, this line item focuses on all development property investments, including those with a Profits Interest.
(b)	The valuation technique for the development property investments with a Profits Interest does not differ from the development property investments without a Profits Interest. The development property investments with a Profits Interest only require incremental valuation techniques to determine the value of the Profits Interest. Therefore this line only focuses on the Profits Interest valuation.
(c)	Eighteen properties were 40% - 100% complete, thus requiring a capitalization rate and/or discount rate to derive entrepreneurial profit, which are used to derive the enterprise value input to the OPM. Capitalization rates are estimated based on current data derived from independent sources in the markets in which the Company holds investments.
(d)	The exit dates for the development property investments are generally the estimated date of stabilization of the underlying property. The exit dates for the operating property loans are the contractual maturity dates.

The fair value measurements are sensitive to changes in unobservable inputs. A change in those inputs to a different amount might result in a significantly higher or lower fair value measurement. The following provides a discussion of the impact of changes in each of the unobservable inputs on the fair value measurement.

Market yields - changes in market yields and discount rates, each in isolation, may change the fair value of certain of the Company’s investments. Generally, an increase in market yields or discount rates may result in a decrease in the fair value of certain of the Company’s investments. The following fluctuations in the market yields/discount rates would have had the following impact on the fair value of our investments:



	Increase (decrease) in fair value of investments
Change in market yields/discount rates (in millions)	June 30, 2018		December 31, 2017
Up 25 basis points	$	(2.0)	$	(1.2)
Down 25 basis points, subject to a minimum yield/rate of 10 basis points		2.1		1.2

Up 50 basis points		(4.0)		(2.3)
Down 50 basis points, subject to a minimum yield/rate of 10 basis points		4.2		2.4

Capitalization rate - changes in capitalization rate, in isolation and all else equal, may change the fair value of certain of the Company’s development investments containing Profits Interests. Generally an increase in the capitalization rate assumption may result in a decrease in the fair value of the Company’s investments. The following fluctuations in the capitalization rates would have had the following impact on the fair value of our investments:



	Increase (decrease) in fair value of investments
Change in capitalization rates (in millions)	June 30, 2018		December 31, 2017
Up 25 basis points	$	(5.5)	$	(2.8)
Down 25 basis points		6.0		3.1

Up 50 basis points		(10.6)		(5.3)
Down 50 basis points		12.7		6.4

Exit date - changes in exit date, in isolation and all else equal, may change the fair value of certain of the Company’s investments that have Profits Interests. Generally, an acceleration in the exit date assumption may result in an increase in the fair value of the Company’s investments.

Volatility - changes in volatility, in isolation and all else equal, may change the fair value of certain of the Company’s investments that have Profits Interests. Generally, an increase in volatility may result in an increase in the fair value of the Profits Interests in certain of the Company’s investments.

Operating cash flow projections - changes in the operating cash flow projections of the underlying self-storage facilities, in isolation and all else equal, may change the fair value of certain of the Company’s investments that have Profits Interests. Generally, an increase in operating cash flow projections may result in an increase in the fair value of the Profits Interests in certain of the Company’s investments.

The Company also evaluates the impact of changes in instrument-specific credit risk in determining the fair value of investments. There were no gains or losses attributable to changes in instrument-specific credit risk in the three and six months ended June 30, 2018 and 2017.

Due to the inherent uncertainty of determining the fair value of investments that do not have a readily available market value, the fair value of the Company’s investments may fluctuate from period to period. Additionally, the fair value of the Company’s investments may differ significantly from the values that would have been used had a ready market existed for such investments and may differ materially from the values that the Company may ultimately realize. Further, such investments are generally subject to legal and other restrictions on resale or otherwise are less liquid than publicly traded securities. If the Company was required to liquidate an investment in a forced or liquidation sale, it could realize significantly less than the value at which the Company has recorded it. In addition, changes in the market environment and other events that may occur over the life of the investments may cause the gains or losses ultimately realized on these investments to be different than the unrealized gains or losses reflected in the valuations currently assigned.

The following table presents changes in investments that use Level 3 inputs:



Balance at December 31, 2017	$	234,171
Net realized gains		-
Net unrealized gains		12,943
Fundings of principal and change in unamortized origination fees		169,702
Repayments of loans		(3,257)
Payment-in-kind interest		9,410
Reclassification of self-storage real estate owned		(35,281)
Net transfers in or out of Level 3		-
Balance at June 30, 2018	$	387,688

As of June 30, 2018 and December 31, 2017, the total net unrealized appreciation on the investments that use Level 3 inputs was $28.7 million and $26.3 million, respectively.

For the three and six months ended June 30, 2018 and 2017, substantially all of the change in fair value of investments in the Company’s Consolidated Statements of Operations were attributable to unrealized gains relating to the Company’s Level 3 assets still held as of the respective balance sheet date.

Transfers between levels, if any, are recognized at the beginning of the quarter in which the transfers occur.