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, theres reason to be optimistic that 2013 will see lower rates, higher volumes, and higher leveraged loan options. For many storage owners, that means nows 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 youre making the right choice.
What Type of Prepayment Penalty Do You Have?
First, lets 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. Its 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.
In many ways, defeasance is similar to yield maintenance, except instead of a complete payoff, the collateral for the loan is swapped from the real estate to securities bearing the same cash-flow stream. As with yield maintenance, as interest rates rise and time passes, the resulting penalty will decrease. Unlike yield maintenance, its possible in a rising interest-rate environment for defeasance to become an asset to the borrower. If current rates are significantly higher than the rate on the loan, the result may be a payoff amount below the outstanding loan balance.
There will be additional costs to defeasance, as it takes a specialist to ensure the calculations are done correctly. There are a number of online tools that estimate the cost of yield maintenance and defeasance, such as this one: www.thebscgroup.com/commercial-real-estate-defeasance-calculator.html.
Should I Refinance?
Now that you've calculated the cost of prepayment, the more complicated question is whether this is the right time to refinance. The simplest way to decide this is to first compare the cost of the prepayment penalty, plus any transaction costs for the new loan, with the interest savings from the reduced interest rate for the remaining term of the loan. If the savings is positive, you could conclude this is a good time to refinance. Additionally, the new lender will likely allow the prepayment penalty to be rolled into the new loan to lessen the upfront costs.
However, a strong argument can be made for refinance even if there isnt any immediate interest savings. Managing future interest-rate risk during your investment horizon might be an even more powerful reason. With interest rates at historic lows and a slowly improving economy, it seems inevitable that rates will begin to rise in the near future. Managing your future risk by locking in a long-term rate now rather than rolling the dice at loan maturity in a few years is likely worth the cost of prepayment. Even if youre thinking about selling your property, many long-term loans offer assumption features that would be an asset to any buyer should interest rates be higher at the time of sale.
Now is the time to refinance, and every borrower can do his own analysis fairly easily. If you have a prepayment penalty, examine your loan documents to understand your options with your current lender. Next, calculate your penalty and compare it to your potential savings on a new loan. Finally, look at your investment horizon and understand the potential for rising interest rates. The small cost of refinance now may be pennies compared to increased rates in the future.
Noel Cain is a vice president and Casey McGrath is an associate vice president at Chicago-based The BSC Group , a commercial real estate financing advisor and provider of debt and equity capital solutions for self-storage owners nationwide. Cain provides mortgage brokerage, financial consulting and loan-workout solutions. Reach him at 847.778.4661 or [email protected] . McGrath provides analytical support and mortgage brokerage solutions for a diverse set of clients. Reach him at 312.878.7561 or [email protected] .