Whether in our personal or professional lives, getting ahead of the curve sure feels great. Finish those household chores early? Say hello to your remote control and a weekend of NFL games! Complete that work project ahead of schedule? A long weekend sure is awesome!
But before you get ahead of the curve and prepay self-storage property loans, you’ll want to understand your options, related costs, and how they could affect your refinancing plans and business operations. Lenders commonly incorporate prepayment premiums or penalties into fixed-rate loans to counteract potential lost interest resulting from an early payoff. These penalties take various forms, with the most common structures being step down, yield maintenance and defeasance.
Option 1: Step-Down Prepayment
This is the "traditional" prepayment penalty with commercial banks and life insurers. In a step-down structure, a borrower can repay the loan prior to its maturity but will incur a penalty equaling a specified percentage of the outstanding loan amount, with this percentage declining over time. For example, in a five-year balloon loan, the penalty might be calculated as 4 percent, 3 percent, 2 percent, 1 percent, open to prepayment for years one through five respectively. These loans are typically due and payable upon transfer of ownership and are not assumable.
The other two prepayment penalties are seen primarily in CMBS (commercial mortgage-backed securities) conduit loans and based on insulating the lender—in this case, the bond holders—from negative prepayment impacts. CMBS loan prepayments are typically only available after a two-year lockout period following loan securitization. Most also have an open period three months prior to maturity, which allows borrowers to pay off the loan without penalty.
CMBS loans are also always assumable, so if interest rates increase in the future and you decide to sell your storage property, the next owner could capitalize on the mortgage’s remaining low fixed rate.
Option 2: Yield Maintenance
With a yield-maintenance penalty, borrowers bridge the difference between the amount of interest the loan would earn if carried to term and the interest it would earn if the lender reinvested the borrower's prepaid principal in similar-term Treasury securities. Yield maintenance assesses the borrower a one-time fee that enables the investor—reinvesting at current rates—to receive what it would have earned had the borrower not prepaid. The fee equals the difference (usually discounted to present value) between the original note rate and Treasuries, with durations calculated between the payoff and maturity date multiplied by the prepayment amount.
Should comparable Treasuries be higher than the note rate, you can’t pay the loan at a discount since yield-maintenance guidelines require at least a 1 percent penalty of the remaining loan amount. The calculation formula varies among lenders, so review them closely.
A yield-maintenance provision can usually be inserted into CMBS loan documents to replace the defeasance clause, with the lender commonly adding a .03 percent to .05 percent premium over a defeasance prepayment rate.
Option 3: Defeasance
Defeasance is a collateral substitution involving several parties and requiring approximately 30 days for completion. Defeasance provisions require prepaying borrowers to provide Treasury obligations exactly matching the cash flow of all scheduled mortgage payments.
Defeasance allows a prepaying borrower to replace his mortgage with a carefully assembled package of non-callable, non-prepayable U.S. government obligations to substitute for the loan’s remaining payments. A loan can also be defeased at a discount if average yields on the government securities portfolio exceed the note’s interest rate.
Regardless of whether the defeasance results in a premium or discounted amount, you’ll pay a minimum of $45,000 in organization costs given the complications of accumulating a matching set of Treasury obligations. Defeasance costs cover bond trader services, the rating agency’s opinion, master servicer processing fees, a certified public accountant’s determination that the substituted collateral’s cash flow will meet scheduled mortgage payments on time, a legal opinion that the borrower has met all compliance requirements, and formation of a special purpose entity to act as successor.
Is a Fixed-Rate Loan My Best Option?
Answering this question starts with considering how long you’ll hold your property and the feasibility of locking into a prepayment-penalty exposure. If you plan to refinance the property again, sell relatively soon (one to three years), or can’t project your investment horizon, variable-rate financing may be better since it typically has little to no prepayment penalties.
Credit unions are another option to consider since they don’t assess fixed-rate loan prepayment penalties. Banks can also be flexible with prepayment penalties, however, they may adjust their upfront pricing accordingly.
Given the choice of the three outlined prepayment methods, most borrowers would prefer the step-down option since it’s highly definable throughout the loan period and not subject to interest-rate fluctuations, convoluted formulas or stringent requirements. However, the other loan terms such as the loan-to-value, interest rate or recourse provisions may not suit the borrower’s overall objectives. In those circumstances, the borrower may look to more aggressive CMBS loans, which have the yield-maintenance or defeasance clauses.
Defeasance and yield maintenance primarily depend on loan size. With defeasance, you may receive a discounted payoff, however, your loan has to be large enough so the discount offsets the $45,000-plus in related costs.
In a yield-maintenance option, you’ll likely pay a slightly higher interest rate but won’t incur processing costs other than a nominal servicer fee for a prepayment-penalty calculation. However, regardless of how high interest rates go, you still would be subject to a 1 percent penalty. Given that self-storage CMBS loans are typically less than $5 million, yield maintenance is a great option. But if you don’t plan to prepay the loan, stick with defeasance language and avoid a yield-maintenance interest-rate premium.
Should You Bite the Bullet?
If your loan has 18 months or fewer until maturity, consider biting the bullet, prepaying the loan and incurring related penalties. Assuming your CMBS loan has one year remaining, you’ll likely be hit with a 5 percent to 7 percent prepayment cost. However, that fee is offset by savings from your interest-rate reduction, for example, from 6 percent to 4.5 percent or less.
Your property likely also has “trapped equity,” and you can obtain a significant cash-out even after prepayment penalties. With today’s interest-rate environment, you can also lock into incredibly low rates for another five to 10 years. CMBS lenders are most aggressive with refinancing cash-outs, while banks often prefer owners retain some of their initial property investment.
Waiting to prepay carries a downside risk: Interest rates may rise, and you’ll pay a higher rate going forward. In addition, depending on how high rates go, your loan proceeds may be cut due to debt-service requirements.
Prepayment provisions are certainly a drawback to fixed-rate financing. But in today’s low interest-rate environment, cost savings of low fixed-rate loans provide many good reasons for you to get ahead of the curve.
Neal Gussis is a principal at CCM Commercial Mortgage, a mortgage-banking firm that secures financing for self-storage owners nationwide. The company works with an extensive network of capital providers and has funded more than $1 billion in self-storage transactions. For more information, call 847.922.3750; e-mail [email protected]; visit www.ccmcommercialmortgage.com.
