In CRE financing, there are various loan prepayment penalties if loans are sold or refinanced prior to maturity. These prepayments can easily be in the millions of dollars and can severally hamper the ability for ownership to capture any equity value creation. In this article, we will provide background on these prepayment penalties, the various types of penalties and considerations that sponsors and passives should take before investing in their next deal.

Background

In the single-family residential world, most investors or homeowners are aware of the popular 30-year fixed-rate loan that is widely used. These loans are great because the term and interest rate is fixed for 30 years giving homeowners security. However, the real reason these loans are attractive is that they usually have no prepayment penalty for selling or refinancing before the end of the 30 year term. This is a big deal especially considering research from ATTOM Data Solutions indicated that the average homeowner tenure was 8 years in 2019. If there were prepayment penalties associated with these loans, they would be viewed not as favorably.

In the commercial real estate world, including multifamily, the loans placed on most properties come with some type of prepayment penalty whether they are agency, bank or bridge loans. Furthermore, commercial loans rarely have terms of 30 years and are usually shorter 3-10 year terms, which require the loans to be paid off in full at the end of the term.

Conventional Thinking

Long-term fixed-rate debt has long been viewed as prudent as it’s consistent and there are no interest rate risks that are out of an owner’s control. Furthermore, interest rates had been much higher in decades pre-2008 recession and rates post recession were ‘historically’ very low. As such, many ownership groups had the mindset of going long on fixed rate debt. The rationale was that rates may eventually go up and if they do, then the low interest rate on the current loan would be attractive for a new buyer to assume the existing loan upon a sale. Click here to find more information about multifamily loan assumptions.

Going long on term and interest rate makes sense if the business plan is truly long term (i.e. an individual legacy asset, a small partnership, etc.) but does it make sense to take out a 12 year fixed rate loan for a syndication that is pitched as a 3-5 year hold?

It may or may not and it depends on the business plan and on the flexibility of the prepayment penalty, which is covered below.

Types of Prepayment Penalties:

The following are the different types of prepayment penalties commonly seen in the multifamily world:

Step-Down (or Fixed %)

These are most common in bank or bridge debt and is usually a gradually declining penalty over the term of the loan. A 5-year loan may have a 5-4-3-2-1 prepayment penalty. The numbers represent the penalty as % of the loan amount in the year of prepayment. For example, a $10M loan will have a $500K if paid in year 1, $400K if paid in year 2, $300K if paid in year 3, etc. There are also floating rate loan products that typically have a set percentage of 1-2% fee after a certain lock-out period, if the loan is paid early.

Pros: Relatively low and known cost to exit the loan

Cons: Higher interest rate

Other: Agency loans can be done with step-down but they must be requested and come with a higher interest rate.

Yield Maintenance (YM)

YM is the common prepayment structure for Agency loans. Given that the agencies securitize the loans and sell them as mortgage back securities (MBS), the YM penalty essentially enables the lender to attain the same yield as if the borrower held the loan until the maturity date.

The YM penalty is calculated as the difference between the amount of money the lender would have made from remaining interest payments and how much they can earn by reinvesting the loan dollars. The proxy for the reinvesting scenario is usually the US Treasury Bill. As US Treasury rates decrease as compared to the original interest rate, the YM increases and as the treasuries increase, the YM will decrease.

Pros: Lowest interest rates and best terms

Cons: Higher cost to exit and lack of control/flexibility

Other: Agency loans can be structured where YM ends a few years before maturity, which gives some more alignment and flexibility. However, this usually comes with a higher interest rate. 

Defeasance

Defeasance is most common with CMBS loans and is the cost the borrower must incur to substitute the current collateral (the asset) with new collateral, which is usually a US treasury bond. Similar to YM, as rates decrease, the cost of the new treasury increases and vice versa. With YM the actual mortgage note is paid off, but with defeasance the note and payments continue to maturity.

Pros: Generally low rates and higher leverage

Cons: Generally not assumable loans and high cost to exit

Other: Complicated and expensive process to conduct defeasance as may require external consultants. 

Considerations Before Investing In Your Next Deal

For example sake, let’s assume a property was purchased at $15M with a $12M and that the loan was originally a 12 year term at a 5% interest rate. The owner has created substantial value and 2 years later the property is worth $18M and the owner wanted to sell. As of this writing (Q4 2020) where rates are ~3%, the prepayment penalties to exit the loan range from $3M+ with YM/Defeasance$600K with step-down or $120K with a floating rate loan. With the benefit of hindsight, it’s easy to see that the step-down or floating rate options are extremely more reasonable than YM.

The alignment of the business plan with the debt is very critical in any acquisition. CRE investing is highly attractive given the leveraged returns but the debt structuring can have a huge impact on the timing and realization of such returns. The second consideration is the investors view on the direction of future interest rates as these have a huge impact on YM/Defeasance calculations.

Lately, floating rate loan products have been the buzz in the industry given it’s flexible exit penalty (usually 1% after a 12 month lock out period), especially as many owners are handcuffed to their YM loans. Generally, floating rate loans are considered more risky given the interest rate risk, but rate caps can be bought to mitigate the risk making it an attractive option especially in an environment where interest rates are expected to be low going forward.

As a sponsor or passive investor, it’s important to ask the following questions when evaluating a deal to invest in:

  • How long is the business plan for this project? Does the debt enable me to exit upon completion of the plan?
  • What are my views on long-term interest rates?
  • How plausible is a refinance on this deal that will enable me to cash-out during the hold period?
  • What is my risk tolerance for floating rates? Do rate caps mitigate my risk?
  • If I prefer to have a fixed rate, should I pay a premium and get step-down prepayment or have YM end prior to maturity, to have more control and flexibility to exit?

Summary 

As evidenced, loan prepayment penalties can have a huge impact, both negatively and positively, on the outcome of a deal in the multifamily world. As an investor it’s important to ask key questions to assess what type of prepayment penalty makes sense for the deal. The key factors include alignment to business plan, view of interest rates long term, exit flexibility and overall appetite for risk. Working with a lender or mortgage broker that takes the time to understand your strategy and advises on the right products is very important.