Understanding Prepayment Penalties in Commercial Real Estate Loans

Prepayment penalties are an important consideration for anyone looking to pay off a commercial real estate (CRE) loan ahead of schedule. As borrowers evaluate their options, it’s critical to understand how these penalties work, why lenders impose them, and the impact they can have on your financial strategy. The following guide breaks down the main types of prepayment penalties so you can make informed decisions about your CRE financing.

How do prepayment penalties work?

If you obtain a commercial real estate loan and pay it off early, it is likely you will experience a prepayment penalty. Prepayment fees are not meant to punish borrowers—they exist because lenders expect to earn interest over the full life of the loan and when a loan is paid off early, that expected income disappears. Prepayment penalties protect that income.

The three common types of prepayment structures seen are yield maintenance, defeasance, and step-downs. They all work differently.

Yield Maintenance

Yield maintenance (YM) does exactly what its name suggests—it helps the lender “maintain” their “yield,” or return, even if the loan is paid off early.

Imagine you have a 10-year loan at 6.5%. After five years, interest rates fall to 4%, and you refinance at the lower rate. From your perspective this is great, but from the lender’s side, they are losing five years of higher interest income. YM compensates the lender for that loss.

YM is based on the remaining loan balance, the present value of the remaining payments, and the difference between your loan rate and the yield on a similar Treasury. Memorizing the formula is not as important as understanding the concept that the lower interest rates fall, the higher the penalty usually becomes.

Pros

• Predictable compensation for the lender.
• Easier to understand and execute than defeasance for the borrower.

Cons

• It can be expensive for the borrower when market rates drop below the current loan rate.

Defeasance

Defeasance is different. Instead of paying off the loan, you replace the real estate collateral with government securities, usually Treasuries, that generate the same cash flow as the remaining loan payments.

This process is more involved than YM. It requires assembling the securities, setting up a trust, and typically working with a defeasance consultant and attorneys. But it can make financial sense when interest rates are high or rising, because the cost of purchasing the securities may be lower than paying a yield maintenance penalty. Defeasance is common on CMBS loans.

Pros

• For the borrower, it releases the property for sale or refinance and can cost less than yield maintenance in certain interest-rate environments.

Cons

• For the borrower, it is more complex and typically involves added legal and advisory costs.

Step-Down

A step-down prepayment penalty is the simplest and most borrower friendly. Instead of calculating formulas or replacing collateral, a step-down is expressed as percentages tied to the outstanding balance. For example, a typical schedule might look like: 5%, 4%, 3%, 2%, 1%. This means:

• If you pay off in Year 1, the penalty is 5% of the balance.
• If you pay off in Year 2, the penalty is 4% of the balance.
• And so on.

Pros

• For borrowers, step-downs provide transparency, and potentially much lower costs if prepayment occurs toward the end of the schedule.

Cons

• Provides less protection to the lender, so not all lenders offer it.

Summary and Next Steps

Prepayment penalties are a significant consideration for anyone looking to pay off a commercial real estate (CRE) loan ahead of schedule. Lenders use these fees to protect their expected interest income, with common structures including yield maintenance, defeasance, and step-downs. Each type operates differently, impacting both the predictability of costs and ease of execution for borrowers. If you’re planning to refinance or sell your property before your loan matures, review your loan documents carefully to identify which penalty structure applies. Consulting with a financial advisor or your servicing team can help you understand the specific costs involved and explore strategies to minimize these penalties. Being informed upfront empowers you to make decisions that best align with your financial goals.