Many borrowers focus (understandably) on loan amount, interest rate and amortization when evaluating different loan proposals. But we have found that, down the road, differences in prepayment penalty calculations can have an equal, or even greater, importance. Here are some general observations about prepay that are worth bearing in mind when evaluating how important flexible prepay is versus yield maintenance/defeasance.
- The higher the “credit spread” the greater the prepayment penalty will be. Credit spread is the spread that, when added to the relevant index (e.g., 10-year Treasuries) determines the all-in interest rate on the loan. But the discount rate used is typically the Treasury rate, not the total interest rate. So, higher spreads result in larger loan payments to discount back but not higher discount rates. This leads to higher NPVs and higher prepayment premiums. Ignoring the time value of money for this example, a 50 bp increase in your rate will mean 50 bps more in prepayment premium for each loan year remaining at prepayment.
- Some portfolio lenders have much “cheaper” prepayment penalties than others. For instance, many life companies have yield maintenance formulas very similar to CMBS lenders. But others offer fixed “step-down” prepayment penalties. In addition to the benefit of knowing exactly what your prepayment penalty would be at any point in the future, often these will end up being much cheaper than the penalties imposed by a yield maintenance or defeasance calculation. For instance, one lender we work with calculates the prepayment premium based on the decline in the Treasury rate over the life of the loan times the amount of time remaining. Since most borrowers think Treasuries are at rates we won’t see again for the foreseeable future, such a provision would result in the ability to pay the loan off at “par” (i.e., no prepayment premium whatsoever).
- Rising Treasury rates result in lower yield maintenance/defeasance calculations than falling Treasury rates. This is because higher Treasury (i.e., discount) rates mean lower Net Present Values and yield maintenance/defeasance is simply the amount by which the NPV exceeds the current loan balance.
- Borrowers often mistakenly believe that the assumability provision of most permanent loans will buffer them from incurring prepayment premiums if they choose to sell. But two things complicate this:
- With rising property values, assumable loan amounts are often at unattractively low leverage points and additional senior loan proceeds or even mezzanine debt is often unavailable.
- To the extent the loan has credit qualification standards for replacement borrowers or, even worse, repayment guarantees, then assuming borrowers may not be able or willing to assume/guarantee the loan.
Though the importance of prepayment may not reveal itself immediately after loan closing, it can become the critical factor in sell vs. refinance decisions in the future. An experienced commercial mortgage professional can help sort through the best option for a given borrower.
Bill Campbell
Knightsbridge Realty Capital, Inc.
949-719-1992 direct
949-633-0543 cell
bcampbell@kbrcinc.com
www.kbrcinc.com