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Understanding Prepayment Penalty Options for Self-Storage Loans

By Devin Huber Comments
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Remember, you can strategically choose a loan product based on individual goals and intended hold period. If recapturing equity and nonrecourse financing are priorities, and there are no plans to sell during the term, CMBS might make the most sense. Meanwhile, if the ability to sell during the term or even refinance early is important, a local bank loan might be a better option.

When Prepayment Makes Sense

Prepaying a loan can be costly depending on the timing of the payment and the applicable penalty. Certain situations may force a borrower into a very costly proceeding. However, there are times when the pros of prepaying outweigh the cons. In a yield-maintenance or defeasance situation, it’s a good idea to conduct some level of prepayment-penalty analysis (or hire a professional to do one for you).

I’ve found it makes sense to pay the defeasance or yield-maintenance premium in situations where there’s significant equity trapped in a property and a refinance would generate substantial cash out. Consider this real-life example:

A $5 million CMBS loan was placed on a self-storage asset five years ago, with an interest rate of 6 percent. At the time, the property had cash flow of $500,000, and physical occupancy was in the low 80 percent range. Cap rates were at 7.5 percent, rendering a value of $6.67 million. Today, occupancy has increased to 92 percent, rents are up 20 percent, cap rates have compressed to 6 percent and net operating income (NOI) has ballooned to $680,000. The defeasance cost to refinance this loan is approximately $1 million (20 percent of the original loan balance).

That seems pretty steep, right? Keep in mind, though, that when considering the terms of a new loan, the cash out accessible to the borrower, coupled with the opportunities to reinvest that cash, might make defeasance a strong strategic play.

Given the growth in NOI and compression in cap rates since origination, the property’s value is now more than $11 million, which could reasonably fetch a loan of about $8.25 million. After paying off the loan and defeasance penalty, the borrower is left with a $2.25 million cash-out. In addition, he locked into a new 10-year loan at a rate of around 4.5 percent, which is 150 basis points lower than the original rate five years earlier.

Not only is the borrower saving $75,000 per year in interest, he has fresh cash to reinvest. If he’s considering other prospective developments or value-added opportunities, it’s not unheard of to invest that cash in a project generating a double-digit return. Under this scenario, the payback period on the $1 million penalty is rather short. Further, the defeasance penalty is tax deductible, which is valuable to some investors.

While a $1 million defeasance seems unbearable at first glance, consider the flip side: If investment opportunities exist and interest rates are lower than the existing loan’s rate, it may be worth the minor headache.

Know What to Expect

If you plan to hold an asset to loan maturity—and nothing happens during the term to force an early payoff—prepayment penalties may not be a huge concern. Then again, things don’t always go as planned, and it’s valuable to understand what can happen if the unexpected does occur. Though the example above is somewhat simplified, it demonstrates how a real-world prepayment scenario can play out.

A borrower can calculate a step-down prepayment penalty relatively easily. In the case of a more complex prepayment method, such as defeasance, it may be worth the extra cost to hire a professional to conduct the analysis.

Devin Huber is a principal at The BSC Group, a Chicago-based commercial real estate financing firm, where he supports self-storage owners nationwide with their lending needs. His expertise and advisory services span all property types, with a specialization in the self-storage asset class. Prior to helping found BSC, Devin was a senior vice president at Beacon Realty Capital and a key member of the firm's Self Storage Group. To reach him, call 312.207.8232; e-mail dhuber@thebscgroup.com; visit www.thebscgroup.com.

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