Charles:
Welcome to Strategy Saturday; I’m Charles Carillo and today we’re going to be discussing Prepayment Penalties on Commercial Loans.
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Charles:
One of the major differences between residential and commercial real estate loans are pre-payment penalties. Pre-pay penalties are standard on most fixed rate commercial real estate loans, and they greatly impact the total cost of paying off the loan.
Charles:
A pre-pay penalty is designed to preserve the lender’s anticipated profits on a loan. If the investor pays off the loan prior to the loan’s maturity date, they’ll most likely have to pay some form of a prepayment penalty. Most fixed rate commercial real estate loans have a prepayment penalty while most floating rate commercial real estate loans do not. So what types of prepayment penalties do commercial real estate loans have? While there are several different types of penalties, number one is lockout periods. Now, a lockout period occurs when a commercial real estate loan cannot be prepaid in any form until the specified period expires, for example, a five year lockout period. This includes making additional principle payments during the lockout. Number two is fixed prepaid penalties. A fixed pre-pay penalty charges a set fee. If a commercial real estate loan is paid off prior to maturity and within the applicable time period in which the penalty is in effect, usually it is a percentage of the remaining loan balance.
Charles:
For example, a fixed 3% pre-paid penalty for five years will mean that if the borrower wanted to pay off the loan within five years, they would need to pay off the loan in full plus 3% of the outstanding loan amount. Number three is step down prepay penalties. I have found step down prepaying penalties to be the most common prepaying penalty when dealing with local banks. This declining prepay penalty charges a percentage of the outstanding loan amount similar to a fixed prepay penalty, but the percentage decreases over the prepay penalty timeframe. For example, a common prepay penalty on a 10-year loans is; 5,5 4,4 3,3 2,2 1,1. That means that in the first two years of the prepay penalty is 5%, and then in the years three and four of the loan, it is 4% and so on. I recently sold a property that had a 3 21, meaning the first year it had a 3% prepaid penalty that dropped at 2% in year two and 1% in year three.
Charles:
Yield maintenance, prepay and penalties. Now, this is a more complex prepay penalty. Yield maintenance is typical with agency loans, and it is a prepay penalty that borrowers pay to lenders to compensate for the loss of interest resulting from the prepayment of a loan. Yield maintenance is intended to discourage commercial borrowers from prepaying. The loan yield maintenance is calculated by taking the loan’s unpaid principle balance and multiplying that by the loan’s interest rate minus the current US treasury yield with a similar maturity date. This is better for the borrower when the US treasury rates increase during the whole time in the property and become more expensive when US treasury rates decrease. If you have a loan at 4% with two years left till maturity, if the current two year US treasury is more than 4%, you are in great position. If it is less than 4%, you’ll need to make up that difference.
Charles:
Number five is the feasance prepay penalties. Also a more complex prepay and penalty. Defesence is a substitution of collateral. It is used with commercial mortgage backed securities CMBS, the borrower is substituting the property within the loan with treasury bonds to generate cash flows required to meet the scheduled payments and principle in interest remaining on the loan. This allows the borrower to of technically avoid a prepayment penalty since the lender is maintaining the same rate of return as the original loan agreement. The cost to refinance are tied directly to the price of US treasury bonds. Bond prices increase when interest rates fall, so the government treasuries purchase for a to feasance portfolio are more expensive when rates are low. In a low rate environment, diff feasance is used to refinance as the borrower can capture long-term savings via a lower interest rate. By contrast, when interest rates are high, the defesence costs are lower, but the benefits of a refinance are much smaller.
Charles:
Lastly, there are nearly a dozen third parties that are paid fees from the borrower during the prepayment strategy. When it’s de fees in its prepayment penalty, most fixed rate commercial real estate loans will have some sort of prepayment penalty. If you’re obtaining your loan from a local bank or credit union, you’re going to have the most leverage in negotiating all the fees associated with your loan, including your prepayment penalty. A mentor of mine once stated that once you get the fee scheduled from the bank, mark it up and send it back to them. And I’ve success successfully negotiated appraisal fees, origination fees, and more by simply just asking. If you’re dealing with an agency lender for loans $1 million and above, the higher the loan amount, the more you can ask for. A $2 million loan will not have much negotiating power, but a 20 million loan will.
Charles:
However, in both cases, you probably will not be able to fully remove a prepay penalty. I would however, ask if the loan is consumable. Having a loan that is consumable will allow a property buyer to take over the debt from the seller. Usually, this is available with agency loans where the prepay penalties are much steeper. Most banks will not allow a loan to be consumable. Now, prepay penalties are accessed when the loan is paid in full prior to maturity. In other words, when you sell the property or refinance it. Now, reviewing the commercial real estate loan options, make sure to take PREPA penalties into consideration. Not if the rate on the loan is fixed or a variable. There are different loans available for different business plans. Long hold periods on stabilized properties might warrant long-term fixed rate debt, where a property you plan own for two to three years might just warrant a five year fixed loan or a bridge loan with an interest rate cap. So I hope you enjoyed. Please remember to rate, review, subscribe, submit comments and potential show topics at globalinvestorspodcast.com. Look forward to two episodes next week. See you then.
Announcer:
Nothing in this episode should be considered specific, personal or professional advice. Any investment opportunities mentioned on this podcast are limited to accredited investors. Any investments will only be made with proper disclosure, subscription documentation, and are subject to all applicable laws. Please consult an appropriate tax legal, real estate, financial or business professional for individualized advice. Opinions of guests are their own information is not guaranteed. All investment strategies have the potential for profit or loss. The host is operating on behalf of Syndication Superstar, LLC, exclusively.
