Prepayment Penalties: What Self-Storage Operators Need to Know Before a Refinance

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By Noel Cain and Casey McGrath

Interest rates are at an all-time low, lenders have loosened credit significantly and are more aggressively pursuing deals. Because of this, many would agree this is the perfect time for self-storage owners to refinance.

Rates have fallen from near-term highs in 2009 back to reality. Commercial mortgage-backed security (CMBS) debt has fallen to rates in the 4 percent to 4.5 percent range for 10-year, fixed-rate, non-recourse money, which is very aggressive by long-term historical standards. Likewise, traditional bank debt is seeing similar decreases in interest rates for three- and five-year debt.

In the same breath, lenders are opening up their coffers, and lending volume is up. By some estimations, CMBS debt is projected to reach $75 billion in 2013, up from $48 billion in 2012. As bank failures become less common and surviving banks repair their balance sheets, local banks will likely be lending in higher volumes going forward.

Finally, those same lenders are loosening their underwriting standards and sizing metrics and are able to lend at higher leverage points. Many local banks are extending proceeds 75 percent of value, up from 65 percent several years ago. CMBS underwriters are more liberally underwriting revenue, for example. Self-storage properties that are leasing up nicely can sometimes be underwritten using a trailing six-month annualized revenue today. This was non-existent in the market a year ago.

By many standards, there’s reason to be optimistic that 2013 will see lower rates, higher volumes, and higher leveraged loan options. For many storage owners, that means now’s a good time to refinance.

But what if your current loan has a prepayment-penalty feature such as defeasance, yield maintenance or a fixed schedule? Are you left watching from the sidelines as other borrowers take advantage of the favorable market conditions? Are you simply forced to wait it out, keeping your fingers crossed that inflation stays in check? The answer is "maybe."

Let's look at each type of prepayment penalty and discuss the solutions that get you out of your current loan. We'll also address the analysis that should be done to determine if you’re making the right choice.

What Type of Prepayment Penalty Do You Have?

First, let’s discuss the most common prepayment penalties and the potential costs of each. The simplest is the fixed schedule. This type is common with banks and many Small Business Administration lenders, and has a fixed penalty amount depending on the number of years until maturity. For example, this could be 5 percent in year one, 4 percent in year two, 3 percent in year three, etc. This type of penalty often declines as the number of payments remaining decreases and may eventually burn off.

Calculating the penalty is as simple as taking your most recent mortgage statement and multiplying the outstanding debt by the current penalty amount. This total will simply be added to your payoff statement at closing.

Yield maintenance is more common with long-term balance-sheet lenders such as life-insurance companies and occasionally CMBS lenders. Simply put, yield maintenance allows the lender to achieve the same yield on the loan regardless of the fact that the borrower is prepaying. It’s a function of the amount of time left on the loan and the difference between the interest rate on the loan and the current interest rate in the market. As interest rates rise and time passes, the resulting prepayment penalty decreases. However, lenders will often stipulate a minimum penalty of 1 percent.

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