Choosing the right financing option for your commercial real estate acquisition is critical, and there are so many options available. The length of loan term, the interest only period, the interest rate, the leverage – all are important factors to consider when locking in your financing and should support the business plan for the property.
Agency loans (defined as loans originated by the government sponsored agencies of Freddie Mac or Fannie Mae) are the most sought after loan type due to their longer amortization, non-recourse liability, and extremely low interest rates. But one of the most important decisions with agency debt is the type of prepayment penalty to choose as it can materially affect your ability to sell the asset.
What are prepayment penalties?
Prepayment penalties are fees paid to the lender if you pay back the loan prior to its maturity date. If you get a loan with a 10-year term but sell the asset in year 5 the lender is missing out on 5 years of interest on the loan. They’re going to want some assurance they don’t miss out on those earnings – and that comes in the form of a prepayment penalty. If you sell early you will have to pay them some lump sum at close to compensate them for that missed interest.
What are the different penalty types?
Prepayment penalties are structured in one of two ways: Yield maintenance vs. step-down. What the heck do these mean? Let’s start with the simplest form – step-down.
Step-down prepayment penalties are structured as a preset schedule of penalties in each year of the loan term, usually as a percentage of the outstanding balance. There are many specific schedules, but take a 5 year term loan as an example. You can expect to see a schedule of 5-4-3-2-1 which means:
- If you sell in the first year, you will pay 5% of the loan balance
- If you sell in the second year, you will pay 4% of the loan balance
- If you sell in the fifth (and final) year, you will pay 1% of the loan balance
It’s a pretty simple concept. And that’s the beauty of a step-down prepayment schedule - it’s predictable and easily understood. Even by me. Which brings us to... the yield maintenance penalty structure.
The yield maintenance prepayment penalty serves the same purpose as step-down (ensuring the lender is compensated for the loan no matter the actual loan lifespan) but does so in a much different way. Whereas step-down establishes up front what the penalties are, yield maintenance kicks the can down the road and is akin to saying “we’ll figure it out when it’s time to sell depending on a variety of market conditions”. Sound wishy washy? Well, yes. This approach has a much wider range of outcomes. But the underlying formula is knowable.
So how does your prepayment penalty get calculated here? At the time of sale the lender is going to look at your current loan balance, how much time is left on the loan term, the interest rate of the loan, and what interest rate they could earn at that time. The delta between what they would have earned from the remaining time on your loan and what they could earn in the market over the same time period becomes your prepayment penalty lump sum on close.
Let’s look at an example. Say I have another 5 year term loan at 4% with yield maintenance. I crush my business plan and look to sell in year 2. The lender is going to run an analysis that looks something like this:
(3 years left * 4% interest/year) - (3 years * current 10-year Treasury interest rate) = lost earnings
That’s the difference between what the lender expected to earn on your loan and what they can expect to earn on a similar risk-adjusted investment when your loan ends early (the 10-year Treasury with the same maturity date as the current loan is the most common comp).
Which one is right for your loan?
Ok. So the lender is going to get their money no matter what. How do you choose the best options for your loan? The answer is, of course, it depends.
I like to think of most decisions as a series of trade offs. What might be seen as a pro in one context could be a con in the other. It’s important to list these out when making your decision so it’s clear what you’re basing the decision on.
There are three primary factors I consider for each penalty type. They are 1) how sure I am of my sale year 2) what kind of interest rate environment I expect during the loan term and 3) how important cash flow is to my deal.
If I am very certain of my business plan and exit year, then the more predictable step-down prepayment structure is probably the better choice since I will know at purchase what my exit costs will be. However, if my range of sale outcomes is much broader, then it may not be in my benefit to lock myself into a specific schedule.
Also, if I feel confident that interest rates will rise between now and when I sell the property, then yield maintenance may be the better option (remember, if the lender can make more money with the 10-year Treasury in the future than my loan then I may not have to pay any penalty). I am not one to try and time the market or predict interest rates, but if you are then this may be your deciding factor.
Lastly, there is the fact that you will pay a slight premium if you choose step-down in the form of higher interest rates on your loan. If you want to extract the maximum cash flow from the property during your holding period, then you may want the lowest interest rate which will only be available with yield maintenance. This is possible because yield maintenance ensures the lender a certain return so they can offer a lower interest rate. With step-down there’s a possibility that they will still lose out on their expected return, so it’s a higher risk loan in their eyes. And higher risk means higher interest rate to you.
Best of both worlds?
Still struggling to decide which option is right for you? Well consider another option which is somewhat of a blend of the two structures - the accelerated step-down.
If you have a slightly wider range of outcomes than selling in a specific year, it’s still possible to have the predictability of step-down with what’s called an accelerate step down. This still has specific penalties depending on the year of sale, but instead of being a linear reduction over time, it reduces faster so you have less penalty in the later years.
For example, instead of the 5-4-3-2-1 default schedule, you can pay (in the form of higher interest rates) for a 3-2-1-1-1 or even 3-1-0-0-0. If you want to have the option to sell in a specific range of years then you can accelerate your step down to specifically match those disposition years.
The cost you can expect to pay for locking in an accelerated step down schedule is a range, but using a recent loan of ours it was an extra 40bps in interest rate between yield maintenance and the most accelerated 3-1-0-0-0 step down schedule.
I hope this has helped demystify the rather arcane and opaque topic of prepayment penalties. You’d be surprised how many people in the business I’ve spoken to that don’t understand these options or underlying mechanisms, so don’t feel intimidated if it takes a few times through before you fully grasp all the nuance.
Special thanks to Darryl Boukedes at CBRE for much of the information contained here and for the content review.