FAIR VALUE OF FINANCIAL INSTRUMENTS

9 Months Ended

Sep. 30, 2020

FAIR VALUE OF FINANCIAL INSTRUMENTS [Abstract]

FAIR VALUE OF FINANCIAL INSTRUMENTS

4.  FAIR VALUE OF FINANCIAL INSTRUMENTS

Estimates inherent in the determination of fair value inevitably involve assumptions about future events and actual results may differ from those estimates. The COVID-19 pandemic has adversely impacted and is likely to further adversely impact the self-storage industry, generally, and the Company’s operations and value, specifically. Specific negative impacts could include lateness and, ultimately, uncollectibility of an increased number of rental payments, the length of time required to lease-up recently-constructed properties and the ability to increase rental rates, all of which negatively impact revenue from properties and/or the value of our investments. The full extent to which the pandemic will directly or indirectly impact the Company’s business, results of operations and financial condition will depend on future developments that are difficult to predict. These developments include, but are not limited to, the duration and extent of continued spread of the novel coronavirus, the severity of the virus, the actions to contain the virus or address its impact, governmental actions to contain the spread of the virus and to respond to economic deterioration caused by the pandemic (including rapidly accelerating unemployment rates, business bankruptcies, dislocation of equity and debt markets and a dramatic decline in consumer spending and gross domestic product), and how quickly and to what extent normal economic and operating conditions can resume. Management has considered the foregoing factors and the impact of the pandemic, generally, on the economy, the self-storage industry and the Company and adjusted certain estimates, where relevant, used in the preparation of its fair value measurements.

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 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.

Financial assets and liabilities that are not measured at fair value on a recurring basis are cash, other loans, receivables, the secured revolving credit facility, term loans and payables and their carrying values 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 term loans 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.

As discussed in Note 8, Risk Management and Use of Financial Instruments, interest rate swaps and interest rate caps are used to manage interest rate risk. The valuation of these instruments is determined using widely accepted valuation techniques, including discounted cash flow analysis on the expected cash flows of each derivative and these instruments are categorized in Level 2 of the fair value hierarchy. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities. The fair values of interest rate swaps and interest rate caps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts). The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.

Credit valuation adjustments are incorporated to appropriately reflect the Company's and the counterparty's respective nonperformance risk in the fair value measurements. In adjusting the fair value of the derivative contracts for the effect of nonperformance risk, the Company has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts and guarantees.

The following table summarizes the instruments measured at fair value on a recurring basis 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 with a profits interest	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, the Company 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. An option-pricing method (OPM) framework is utilized to calculate the value of the Profits Interests. At certain stages in the investment's 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.	Level 3

The Company’s development property 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 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 from when construction is substantially complete through stabilization. For the three development property investments that were 40% complete but for which construction was not substantially complete at September 30, 2020, the Company has estimated the entrepreneurial profit adjustment to the enterprise value input used in the OPM to be equal to one-third of the estimated entrepreneurial profit, allocated on a straight-line basis. Seventeen development property 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 September 30, 2020. For the Company’s development property investments at substantial construction completion, a discounted cash flow model, based on periodically updated estimates of rental rates, occupancy, occupancy trends 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 September 30, 2020 and December 31, 2019. 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. The significant unobservable inputs associated with the Philadelphia and Houston investments are not included as the fair value was determined based on the fair value of the underlying collateral. The fair value of the underlying collateral was determined, in part, by using a market comparable approach and an income approach based on a capitalization rate within the range provided below for capitalization rates associated with development property investments with a profits interest.

As of September 30, 2020
	Unobservable Inputs
Primary Valuation			Weighted
Techniques	Input	Estimated Range	Average
Income approach analysis	Market yields/discount rate	6.94 - 9.16%	8.10%
	Exit date (a)	0.83 - 5.94 years	3.65 years
Option pricing model	Volatility	67.03 - 96.75%	78.51%
	Exit date (a)	0.83 - 5.94 years	3.65 years
	Capitalization rate (b)	5.25 - 5.50%	5.43%
	Discount rate (b)	8.25 - 8.50%	8.43%

(a) The exit dates for the development property investments are generally the estimated date of stabilization of the underlying property.

(b) Twenty 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.

As of December 31, 2019
	Unobservable Inputs
Primary Valuation			Weighted
Techniques	Input	Estimated Range	Average
Income approach analysis	Market yields/discount rate	6.89 - 10.16%	8.39%
	Exit date (a)	1.50 - 6.69 years	3.40 years
Option pricing model	Volatility	60.95 - 93.83%	73.24%
	Exit date (a)	1.50 - 6.69 years	3.40 years
	Capitalization rate (b)	4.75 - 5.75%	5.46%
	Discount rate (b)	7.75 - 8.75%	8.46%

(a) The exit dates for the development property investments are generally the estimated date of stabilization of the underlying property.

(b) Thirty-eight 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.

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)	September 30, 2020		December 31, 2019
Up 25 basis points	$	(1.1)	$	(2.1)
Down 25 basis points, subject to a minimum yield/rate of 10 basis points		0.5		2.2
Up 50 basis points		(2.2)		(4.2)
Down 50 basis points, subject to a minimum yield/rate of 10 basis points		0.5		4.5

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 the Company’s investments:

	Increase (decrease) in fair value of investments
Change in capitalization rates (in millions)	September 30, 2020		December 31, 2019
Up 25 basis points	$	(4.8)	$	(10.2)
Down 25 basis points		5.2		11.1
Up 50 basis points		(9.5)		(19.4)
Down 50 basis points		11.0		23.4

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 significant gains or losses attributable to changes in instrument-specific credit risk in the three and nine months ended September 30, 2020 and 2019.

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 were 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 tables present changes in investments that use Level 3 inputs:

Balance at December 31, 2019	$	549,684
Realized gains		—
Unrealized losses		(5,630)
Fundings of principal and change in unamortized origination fees		26,354
Repayments of loans		(13,878)
Payment-in-kind interest		15,219
Reclassification of self-storage real estate owned		(255,495)
Net transfers in or out of Level 3		—
Balance at September 30, 2020	$	316,254

Balance at December 31, 2018	$	457,947
Unrealized gains		28,847
Fundings of principal and change in unamortized origination fees		126,100
Repayments of loans		(361)
Payment-in-kind interest		22,069
Reclassification of self-storage real estate owned		(125,715)
Net transfers in or out of Level 3		—
Balance at September 30, 2019	$	508,887

As of September 30, 2020 and December 31, 2019, the total net unrealized appreciation on the investments that use Level 3 inputs was $36.3 million and $76.8 million, respectively.

For the three and nine months ended September 30, 2020 and 2019, substantially all of the net unrealized gain (loss) on investments in the Company’s Consolidated Statements of Operations were attributable to unrealized gains (losses) 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.