Despite several rate hikes over the last few years from the Federal Reserve, interest rates remain near recent historical lows. Lenders are still aggressively pursuing deals, which means more loans for self-storage borrowers. Many would agree the timing is still advantageous for owners to refinance their existing debt. Prepayment penalties are an important part of your real estate loan terms, and it’s good to understand your options.
Lender and Borrower Strategy
When they originate financing, lenders plan to earn a certain profit through some combination of yield earned on interest-rate spread and points charged on the front or back end of a loan. They rely on prepayment penalties to ensure that if a loan is paid off prior to maturity, they’ll pull in the same yield they would have earned if the loan were carried to term.
It’s extremely difficult to predict changes in the yield curve. Lenders originating longer-term debt are exposed to many years of rate volatility. A longer term will often predicate a more sophisticated prepayment penalty, like yield maintenance or defeasance, to insulate against interest-rate risk. The curve is slightly more predictable over a shorter (three- to five-year) loan term, so lenders have less exposure to rate volatility. In this case, they may be comfortable with a less stringent prepayment penalty, such as a simple step-down method, or even no penalty.
From a borrower’s perspective, prepayment penalties are predictable by lender type. A great strategy is to match your hold period with your loan product. If you intend to hold an asset for a short time, you might be in the market for a bridge, credit-union or local-bank deal. Conversely, long-term holds may be best suited for a commercial mortgage-backed securities (CMBS) or insurance loans.
Penalty Types
Following is a breakdown of the types of prepayment penalties and what they entail.
Step down. This penalty is arguably the simplest prepayment structure for a commercial loan. The step-down method refers to a declining structure—for example, from a 5 percent fee to 1 percent—on a five-year loan. Effectively, the fee would be 5 percent in year one, 4 percent in year two and so on, until a 1 percent fee is imposed in year five. Further, banks may offer open prepayment during the last 90 days of the loan.
Defeasance. This method means replacing the collateral that generates the anticipated stream of debt-service payments, which is frequently achieved with some combination of government securities. The cost to defease decreases as rates increase and vice versa.
Disadvantages of defeasance are the time and complexity of securing the replacement collateral as well as the ancillary costs. Defeasance is typically the most time-intensive of all prepayment methods to execute—to the tune of 30 to 45 days. Additional costs may include legal fees, consultant fees, bond-trader fees, servicer fees and more. One distinct advantage is the absence of a prepayment floor. If rates have risen since origination, there are cases where it can be advantageous for the borrower to defease.
Yield maintenance. This prepayment structure consists of two payments: outstanding principal balance on the existing loan and a predefined prepayment fee. There are several methods to calculate the penalty associated with yield maintenance. While not quite as simple as the step-down structure, it’s certainly more straightforward than defeasance.
As with defeasance, the cost of yield maintenance decreases as rates increase. However, yield maintenance typically includes a prepayment floor that prevents this structure from becoming an asset for a borrower. The floor is typically 1 percent, which curbs the benefit that may be realized with defeasance in a rising rate environment.
Comparing Options
Yield maintenance and defeasance are typically the most time-intensive and costly structures, and commonly offered by CMBS lenders. CMBS products aren’t selected for their prepayment flexibility, but rather for their long-term, fixed-rate, nonrecourse nature. Step-down prepayment structures are typical of life-insurance products, local and regional banks and some bridge lenders. Open prepayment is popular among credit unions.
Remember, you can strategically choose a loan product based on individual goals and intended hold period. If recapturing equity and nonrecourse financing are priorities, and there are no plans to sell during the term, CMBS might make the most sense. Meanwhile, if the ability to sell during the term or even refinance early is important, a local bank loan might be a better option.
When Prepayment Makes Sense
Prepaying a loan can be costly depending on the timing of the payment and the applicable penalty. Certain situations may force a borrower into a very costly proceeding. However, there are times when the pros of prepaying outweigh the cons. In a yield-maintenance or defeasance situation, it’s a good idea to conduct some level of prepayment-penalty analysis (or hire a professional to do one for you).
I’ve found it makes sense to pay the defeasance or yield-maintenance premium in situations where there’s significant equity trapped in a property and a refinance would generate substantial cash out. Consider this real-life example:
A $5 million CMBS loan was placed on a self-storage asset five years ago, with an interest rate of 6 percent. At the time, the property had cash flow of $500,000, and physical occupancy was in the low 80 percent range. Cap rates were at 7.5 percent, rendering a value of $6.67 million. Today, occupancy has increased to 92 percent, rents are up 20 percent, cap rates have compressed to 6 percent and net operating income (NOI) has ballooned to $680,000. The defeasance cost to refinance this loan is approximately $1 million (20 percent of the original loan balance).
That seems pretty steep, right? Keep in mind, though, that when considering the terms of a new loan, the cash out accessible to the borrower, coupled with the opportunities to reinvest that cash, might make defeasance a strong strategic play.
Given the growth in NOI and compression in cap rates since origination, the property’s value is now more than $11 million, which could reasonably fetch a loan of about $8.25 million. After paying off the loan and defeasance penalty, the borrower is left with a $2.25 million cash-out. In addition, he locked into a new 10-year loan at a rate of around 4.5 percent, which is 150 basis points lower than the original rate five years earlier.
Not only is the borrower saving $75,000 per year in interest, he has fresh cash to reinvest. If he’s considering other prospective developments or value-added opportunities, it’s not unheard of to invest that cash in a project generating a double-digit return. Under this scenario, the payback period on the $1 million penalty is rather short. Further, the defeasance penalty is tax deductible, which is valuable to some investors.
While a $1 million defeasance seems unbearable at first glance, consider the flip side: If investment opportunities exist and interest rates are lower than the existing loan’s rate, it may be worth the minor headache.
Know What to Expect
If you plan to hold an asset to loan maturity—and nothing happens during the term to force an early payoff—prepayment penalties may not be a huge concern. Then again, things don’t always go as planned, and it’s valuable to understand what can happen if the unexpected does occur. Though the example above is somewhat simplified, it demonstrates how a real-world prepayment scenario can play out.
A borrower can calculate a step-down prepayment penalty relatively easily. In the case of a more complex prepayment method, such as defeasance, it may be worth the extra cost to hire a professional to conduct the analysis.
Devin Huber is a principal at The BSC Group, a Chicago-based commercial real estate financing firm, where he supports self-storage owners nationwide with their lending needs. His expertise and advisory services span all property types, with a specialization in the self-storage asset class. Prior to helping found BSC, Devin was a senior vice president at Beacon Realty Capital and a key member of the firm's Self Storage Group. To reach him, call 312.207.8232; e-mail [email protected]; visit www.thebscgroup.com.
