In recent years, lenders have seen record volumes of long-term loan requests for commercial property acquisitions. This makes sense as a hedge against rising interest rates. That hedge provides certainty that your interest rate will remain the same for a set period, no matter what market rates do.

It’s important to keep in mind that the lender enters into that agreement with the opposite benefit, so they hedge their risk with time. What does that mean?

If the lender is going to honor the specified rate for an extended period, they need to receive a minimum return on their investment. They accomplish this minimum yield (return) by imposing a penalty if the borrower pays off the loan before a certain date. This date is typically referred to as the “open period.”

Although these long-term fixed rate loans are very attractive, the prepayment penalties can be extremely expensive and dramatically increase the cost of sale. Borrowers, therefore, need to understand the prepayment penalty options available and calculate the impact each will have on overall returns.

Types of Prepayment Penalties

The three most common prepayment penalties associated with these securitized loans are:

  1. Step–down
  2. Yield maintenance
  3. Defeasance

We won’t do a deep dive into the formulas for calculating each type. But knowing the general scope of each form of prepayment penalty will help you understand how the cost of sale can increase or decrease, depending on the specifics of the debt at the time of sale.

1. Step-Down

The step-down prepayment penalty is the simplest to calculate. It is just a percentage of the Unpaid Principal Balance (UPB) at the time of payoff. This percentage will typically decline every one or two years depending on the various lenders’ programs.

A common starting point for most loan programs is 5% of the UPB in year one, and then the penalty declines from there. The decline schedule is often a function of the loan term. For instance, if you structure a 10-year term, it is quite common to see a prepayment penalty that starts at 5% and declines 1% every two years, eventually resting at 1% beginning in year 9.

Once a borrower gets toward the end of the loan term, the prepayment penalty is typically not a major factor and the cost of a sale can be absorbed without dramatically diminishing the returns. That said, each deal will have unique timing and pricing.

2. Yield Maintenance

The yield maintenance form of prepayment penalty is quite common with both Fannie Mae and Freddie Mac loans. Although the actual formula can be rather complicated, the premise of the penalty is in the name itself.

You are agreeing to maintain the yield that you promised to the lender. So, for example, you sell your property with a $3 million UPB, so the lender receives $3 million payoff at closing. They will then invest those funds in an equivalent investment vehicle with the same maturity and earn as much interest as the current market will bear.

Per your agreement, you will make up the difference between your note rate and the market yield at the time of payoff, essentially “maintaining the yield” you promised to your lender. The yield maintenance is in place until the open period, so you will need to maintain this margin for the bulk of the remaining term.

You can see how this prepayment penalty could get extremely expensive, especially in a flat or declining rate environment where that margin is greater. Even when rates are rising, they would need to increase at a healthy pace to offset the fact you are buying an investment vehicle with shorter maturity, which usually pays a lower yield.

2. Defeasance

Defeasance, another form of prepayment penalty, is most seen in conduit, or CMBS, loans. When a defeasance prepayment is executed, the debt is not retired or paid off. It is more of a substitution of collateral.

Because the asset is being sold and is no longer in place to generate revenues to service the debt, the proceeds from the sale are used to purchase securities sufficient to generate a stream of income that will service the debt through the remaining defeasance period.

A third party is used to “defease” the loan, and it is typically a higher cost transaction than yield maintenance or a step-down prepay. If market conditions allow, the seller may benefit from the defeasance and participate in that arbitrage. Please note that this will be spelled out in the loan docs, and the lender will often secure the right to any profits generated above the debt service. You should be able to negotiate and participate in that benefit.

Strategies to Reduce the Impact of Prepayment

The expense associated with any of the above-mentioned prepayment penalties forces investors to pay close attention to their exit strategy and to determine which prepayment structure provides the lowest cost to exit.

The following strategies are commonly used to reduce the impact of a prepayment penalty.

  1. Plan your work and work your plan! In other words, choose a prepayment penalty that burns off close to or at the time you expect to sell or refinance out of the loan. Although this strategy may be cost prohibitive for an early sale, it makes sense for a long-term hold.
  2. Consider a shorter fixed-rate period. Some lenders, such as Freddie Mac, offer a loan structure with a rate that is fixed for a specific period and then converts to an adjustable rate at a specified spread over a specified index. In most loan structures, the prepayment penalty will either be eliminated or drastically reduced once you are out of the fixed-rate period.
  3. Allow a potential buyer to assume the existing note. These loans typically allow for a qualified buyer to assume the existing debt rather than pay it off. In a rising interest rate environment, this may present a more attractive debt structure than what is available in the market.

In this scenario, the investor will often structure a fixed-rate period longer than the intended hold period to allow for a longer “runway“or loan term for buyers to assume. This longer runway allows the originating lender to potentially extend secondary financing, known as supplemental debt, as high as 75% cumulative loan to value to a prospective buyer. Supplemental debt is typically only available with Fannie Mae and Freddie Mac loans and makes for a much more attractive assumption.

So, you can see how it would be beneficial for a seller to avoid the costs associated with prepayment penalties. But, if you have defined an exit timeline, you can structure a prepayment penalty window and prepare for it.

If you are looking for some flexibility with disposition or refinance timing, you may consider a less expensive prepayment penalty for a slight increase in the rate, or possibly a shorter fixed rate.

Finally, a buyer’s ability to assume your loan can be a win/win scenario in the right market. The loan is not being paid off, so you don’t get hit with a prepayment penalty. And, as rates increase, your long term, lower-than-market rate will become more attractive to potential buyers, making the potential assumption more realistic.

It’s important to have a clear understanding of your prepayment penalty options. Make sure to speak with your loan officer or broker about the options available and choose the one that aligns best with your investment strategy.

Eric Stewart is the owner of Atlantic Investment Capita, Inc., a full-service commercial lending advisory and brokerage firm. Stewart has been structuring finance solutions for commercial real estate investors and business owners since 1996, with products ranging from equipment leases to commercial real estate loans as well as assumption representation and consulting.

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Categories | Article | Funding
  • Eric Stewart

    Eric Stewart is the owner of Atlantic Investment Capital, Inc. a full-service commercial lending advisory & brokerage firm. Eric has been structuring finance solutions for both Commercial real estate investors and business owners since 1996 with products ranging from equipment leases to commercial real estate loans as well as assumption representation & consulting. Atlantic currently specializes in structuring finance solutions for investment opportunities in commercial real estate nationwide. Eric also provides an advisory platform for commercial real estate investors. It is based on over two decades of working with clients who are working through the challenges of financing commercial real estate acquisitions

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