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To Prepay or Not Prepay Your Loan? What Every Self-Storage Owner Must Consider Before Refinancing

There are three major prepayment structures self-storage owners could face when refinancing a loan. Here’s what you need to know about each to make an informed decision.

Is the inevitable finally happening? Are interest rates starting to bounce from historic lows and begin their long-awaited climb upward? I don’t have the answer, but what I do know is Treasury yields are up significantly over the past six months. On Jan. 26, the 10-Year Treasury closed at 1.68 percent. On June 10, it was at 2.41 percent, a climb of 73 basis points or 0.73 percent.

The good news is a 10-Year Treasury of 2.41 percent is still a low yield when compared to historic levels, and borrowers can still lock in long-term, fixed-rate mortgages in the mid 4-percent range. Does it then make sense for a self-storage owner to refinance his facility? That depends on your view of the interest-rate markets and the direction you think rates are headed. You must also consider the prepayment penalty on your existing loan and whether the economic consequences are too costly.

There are three major prepayment structures commonly used by lenders today: fixed-percentage or step-down, yield maintenance, and defeasance. Each has advantages and disadvantages. Here’s what you need to know to make an informed decision about prepaying your self-storage loan.

Fixed-Percentage or Step-Down Prepayment

Fixed-percentage or step-down prepayment is the simplest structure. The lender states that a percentage of the unpaid principal balance is required as payment in the event that you pay off the loan prior to maturity. For example, the penalty 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 is common with banks and many Small Business Administration lenders.

The benefit of this type of prepayment is you always know what the cost of the prepayment is regardless of interest-rate movement. However, as we’ll see below, a fixed-percentage prepayment structure isn’t beneficial if interest rates spike.

Yield Maintenance

Yield maintenance allows the lender or investor to maintain the same yield or return as they were generating from their loan. The lender usually looks to the Treasury market for the replacement rate and chooses the Treasury that most closely matches the maturity date of the original loan. The remaining loan payments are then discounted using the replacement rate as the discount factor. The present value of these payments is then compared to the unpaid principal balance of the loan, and the difference is the penalty—if the present value is greater than the outstanding loan amount. As interest rates rise and time passes, the resulting pre-payment penalty decreases and can become nil; the opposite happens if interest rates decrease.

However, lenders will often stipulate a minimum penalty of 1 percent. Yield maintenance is used with balance-sheet lenders making long-term, fixed-rate loans as well as insurance companies. It’s also becoming more common to see commercial mortgage-backed securities lenders using this structure. The advantage is, in a rising-interest-rate environment, it’s possible for the prepayment penalty to drop to 1 percent.

Defeasance

Defeasance is similar to yield maintenance in that the investor is looking to maintain the existing yield. However, with defeasance, the funds used to pay off the loan are employed to purchase a portfolio of Treasuries to emulate the cash-flow stream investors would have received had the loan not been prepaid.

As rates go up, the cost to acquire the replacement collateral goes down. If rates go up enough, you could find yourself with an asset on your hands. However, the opposite is true if rates go down. It should be noted that the transactions cost to defease a loan averages about $55,000 regardless of interest-rate movement or loan size.

Should You Refinance?

Now that you understand the different prepayment structures, you may be wondering if now is the right time to refinance. The easiest analysis to perform is to take the interest savings you would achieve in a refinance over the remaining term of your loan and compare it to the cost of prepaying. If the savings is greater, refinancing probably makes sense.

Of course, decisions are never that easy. There are many other factors to consider. Even if the savings of the new loan don’t justify the cost of prepayment, you must consider where interest rates will be when the existing loan matures. If you believe they’re rising, it may make sense to prepay and lock in a new, 10-year, fixed-rate loan that’s at historic lows so you’re not forced to refinance during a non-favorable interest-rate market.

Additionally, if you believe the real estate market will dip when your existing loan matures, it might make sense to refinance now and extend your term while capital is abundant and values are strong. Some of the storage owners who were hit hardest during the recession were those whose debt matured between 2009 and 2011. Their operations may have been strong, but due to factors out of their control that affected the capital markets, they weren’t able to refinance their existing debt load. Many borrowers were required to contribute equity to refinance.

Another reason we’re seeing borrowers pay hefty prepayment penalties—in excess of 10 percent of the outstanding balance—is they’re able to access significant amounts of cash equity. Over the past five years, the value of self-storage facilities has increased dramatically. This is the result of a lack of new supply, which leads to increased occupancy and higher rents, all resulting in record profitability. Couple this with capitalization-rate compression, and self-storage values are at an all-time high.

Many borrowers are refinancing and paying significant penalties to access this equity. They’re doing so because the return generated by reinvesting the cash more than makes up for the large penalty. In fact, many are refinancing and taking out cash to develop additional self-storage facilities in the current development cycle.

Refinancing your self-storage loan prior to maturation and incurring a prepayment expense won’t make sense for everyone. However, because we’re experiencing a record-low interest-rate environment and self-storage values are at an all-time high, everyone should take the time to perform his own analysis.

Devin Huber is a principal at The BSC Group, which offers financial and loan advisory, mortgage-brokerage and loan-workout solutions to commercial real estate property owners and investors, with a special emphasis on the self-storage market. Prior to helping found The BSC Group, Huber was a senior vice president at Beacon Realty Capital and a key member of the firm’s Self Storage Group. To reach him, call 800.605.7880; e-mail [email protected]; visit www.thebscgroup.com.

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