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Understanding Prepayment Penalty Options for Self-Storage Loans

By Devin Huber Comments

Despite several rate hikes over the last few years from the Federal Reserve, interest rates remain near recent historical lows. Lenders are still aggressively pursuing deals, which means more loans for self-storage borrowers. Many would agree the timing is still advantageous for owners to refinance their existing debt. Prepayment penalties are an important part of your real estate loan terms, and it’s good to understand your options.

Lender and Borrower Strategy

When they originate financing, lenders plan to earn a certain profit through some combination of yield earned on interest-rate spread and points charged on the front or back end of a loan. They rely on prepayment penalties to ensure that if a loan is paid off prior to maturity, they’ll pull in the same yield they would have earned if the loan were carried to term.

It’s extremely difficult to predict changes in the yield curve. Lenders originating longer-term debt are exposed to many years of rate volatility. A longer term will often predicate a more sophisticated prepayment penalty, like yield maintenance or defeasance, to insulate against interest-rate risk. The curve is slightly more predictable over a shorter (three- to five-year) loan term, so lenders have less exposure to rate volatility. In this case, they may be comfortable with a less stringent prepayment penalty, such as a simple step-down method, or even no penalty.

From a borrower’s perspective, prepayment penalties are predictable by lender type. A great strategy is to match your hold period with your loan product. If you intend to hold an asset for a short time, you might be in the market for a bridge, credit-union or local-bank deal. Conversely, long-term holds may be best suited for a commercial mortgage-backed securities (CMBS) or insurance loans.

Penalty Types

Following is a breakdown of the types of prepayment penalties and what they entail.

Step down. This penalty is arguably the simplest prepayment structure for a commercial loan. The step-down method refers to a declining structure—for example, from a 5 percent fee to 1 percent—on a five-year loan. Effectively, the fee would be 5 percent in year one, 4 percent in year two and so on, until a 1 percent fee is imposed in year five. Further, banks may offer open prepayment during the last 90 days of the loan.

Defeasance. This method means replacing the collateral that generates the anticipated stream of debt-service payments, which is frequently achieved with some combination of government securities. The cost to defease decreases as rates increase and vice versa.

Disadvantages of defeasance are the time and complexity of securing the replacement collateral as well as the ancillary costs. Defeasance is typically the most time-intensive of all prepayment methods to execute—to the tune of 30 to 45 days. Additional costs may include legal fees, consultant fees, bond-trader fees, servicer fees and more. One distinct advantage is the absence of a prepayment floor. If rates have risen since origination, there are cases where it can be advantageous for the borrower to defease.

Yield maintenance. This prepayment structure consists of two payments: outstanding principal balance on the existing loan and a predefined prepayment fee. There are several methods to calculate the penalty associated with yield maintenance. While not quite as simple as the step-down structure, it’s certainly more straightforward than defeasance.

As with defeasance, the cost of yield maintenance decreases as rates increase. However, yield maintenance typically includes a prepayment floor that prevents this structure from becoming an asset for a borrower. The floor is typically 1 percent, which curbs the benefit that may be realized with defeasance in a rising rate environment.

Comparing Options

Yield maintenance and defeasance are typically the most time-intensive and costly structures, and commonly offered by CMBS lenders. CMBS products aren’t selected for their prepayment flexibility, but rather for their long-term, fixed-rate, nonrecourse nature. Step-down prepayment structures are typical of life-insurance products, local and regional banks and some bridge lenders. Open prepayment is popular among credit unions.

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