MARKET UPDATE BLOG
Does Your Prepayment Fit Your Business Plan?
Does Your Prepayment Fit Your Business Plan?
July 23, 2020

When shopping for a commercial mortgage, borrowers often focus on interest rates and fees. Though interest rate and loan fees should never be overlooked, borrowers can lose sight of their business plan for the property and how a prepayment penalty or lack thereof will affect its profitability.

The outline below is an explanation of typical available prepayment penalties, along with the pros and cons of each.

Prepayment Options

Defeasance is the substitution of collateral. US securities can be structured to provide cash flow as a substitute for collateral and pay off the loan at maturity. In a defeasance, US securities are pledged to the lender, in exchange for the lender’s release of the real estate from the mortgage.

Pro:

  • Most common prepayment penalty structure for a CMBS loan.
  • If treasury yields move high enough, borrowers can make money through this process.

Cons:

  • Can be very expensive to process.
  • More restrictive option

 

Yield Maintenance is the difference between the note rate and the comparable treasury rate, multiplied by the remaining term of the loan.

Pro:

  • Typical prepay structure for most long-term fixed-rate loans with insurance companies, agency lenders, banks, and some CMBS loans.
  • As interest rates move up, prepayment penalty moves down.
  • For lenders, prevents early prepayment

Cons:

  • Can be restrictive
  • If rates stay the same or move down, it can be very expensive to pay off

 

Yield Maintenance with Step Down is a prepayment penalty where part of the loan term has a yield maintenance penalty and the remainder has a declining fixed interest rate penalty.

Pro:

  • Many insurance companies, banks, and agency lenders offer this structure of prepayment penalty.
  • More flexibility than straight yield maintenance or defeasance.

Cons:

  • Still restrictive
  • Can be expensive, although more flexible than the above.

 

Step Down is a declining fixed prepayment penalty over time.

Pro:

  • Many insurance companies, banks, and agency lenders offer this structure of prepayment penalty.
  • More flexible than the above prepayment penalty options.
  • Borrower knows what their penalty will be at any given time during the loan term.

 

No Prepayment

Pro:

  • Most flexible available penalty.

Cons:

  • Typically comes with credit union loans. Credit unions generally require personal guarantees on the loan and may have a higher interest rate than other lenders with prepayment penalties.

 

David Bruni
Vice President
dbruni@slatt.com
Connect with David on LinkedIn