3 Reasons I’m Paying the Defeasance Penalty — and Other Considerations for Investors | John Darrow
Outside of assisting my clients daily with capital markets insights, expectations, and financing requests, I have also been a real estate investor since 2012. A few weeks ago, I sent the 25K wire to Wells Fargo to start the defeasance process on a 70-unit apartment building I own in Chicago with a few partners. The loan doesn’t mature until 2026 (we assumed the loan when we bought the property in 2020), and the rate isn’t all that bad – 4.72% – which, to be honest, we will be lucky to achieve on the refinance. Further, our defeasance penalty will still work out to be 8% of the UPB (ouch).
I will digress for a minute, as I do not believe there is a strong model in the marketplace that can show an investor whether the metrics of a refinance make sense. By that, I mean if you Google “defeasance” or “yield maintenance,” the first 10 hits will be calculators that show your penalty, and that’s it. In a vacuum, the penalty never looks great, and usually, that number doesn’t help us decide whether to refinance or hold. The analysis doesn’t need to be complicated; it just needs to help us decide if it makes sense to refinance now or hold off until later. Thanks to the help of a very good friend, that calculator was born. Our calculator utilizes NPV and, in essence, runs the current loan out to maturity side-by-side with a new loan originated at today’s rate and terms. We can then employ a sensitivity analysis to play around with a dispersion of future interest rates because I don’t have a crystal ball on where rates will be in 4 years.
Here are the 3 reasons I decided to move forward:
- Yields – The yields on the short end of the curve (3-5YR UST) are up almost 250 bps from last year, but more importantly, the curve is flat, and the 10YR is trading below the 7YR and 30YR (as of 5.3.22 when this article was written). The curve is rewarding borrowers right now to borrow 10YR year paper or longer, as the long end has only moved about 135 bps since last year (less if you are borrowing based on the 30YR UST). In simple terms, just in the last 60 days, my defeasance penalty has gone from 14% of the UPB down to 8%.
- LTV – Lenders commonly look at three metrics when sizing a loan: loan to value (LTV), debt yield (DY), and debt service coverage ratio (DSCR). For those on the East and West coast, max loan proceeds are usually driven by DY or DSCR. When I was originating agency loans in Texas in 2016, proceeds were capped at LTV, but that was back when you could buy multifamily deals at 7 caps. Cap rates today for multifamily nationwide are well lower than that, even if the market is starting to adjust. DY and DSCR are the two metrics I can control; by that, I mean, to increase either DY or DSCR, I solely need to focus on increasing my properties’ NOI. The broader economy and a whole host of other variables come together to dictate values. Anyone trying to value a hotel last year understands how quickly things can change. My point is simply this: relative to the cost of capital, and likely quantitative tightening by the FED, I would argue cap rates for my 70-unit in Chicago are likely as good as I am going to get.
- Amortization vs Interest Only – Our current loan is amortizing, and our new loan will be IO. Whether you prefer amortization or interest-only is usually based on several variables, but in short, I subscribe to the philosophy of leaning FTIO if you are looking to boost your cash flow during periods of renovations or reinvesting in the property (which we are doing now through upgrading units). It also helps to boost IRRs and Cash-on-Cash returns if you have investors in deals. Conversely, amortization will be better for returns if your primary objective is wealth accumulation or capital preservation over the long run.
Where does that leave us? I have a 4.5% fixed rate IO deal that will roll our defeasance penalty into the new loan. Over the next four years (the remaining term we have on our CMBS loan), the principal the new loan will save us is $298k, or $267K if you discount it back based on the 4.5% rate. Although I mentioned above that the market is rewarding you if you fix long, we are willing to pay a bit of a premium to have flexibility in the shorter term, given the rent premiums we anticipate achieving.
Our goal at Slatt Capital is to always provide our clients with informed advice and guidance, especially when the decision is a bit more nuanced.