By Brandon Wilhite

mortgage-prepayment-penaltiesA rise in commercial property valuations, along with prevailing, low interest rates, has caused many owners to consider selling and/or refinancing in order to either realize profits or to unlock and reinvest “trapped” equity.  However, for borrowers with term remaining on their existing fixed-rate debt, mortgage prepayment penalties can add a level of complexity to the decision to sell or refinance.  Generally, there are three types of prepayment penalties.

1)       Predetermined Percentage of Principal Balance – This type of prepayment penalty is most often associated with bank or life insurance company loans in which the loan is held on the lender’s balance sheet.  The prepayment penalties on these types of loans can vary widely but are generally fairly simple.  A typical structure may be a 5-year term loan with prepayment locked out the first two years, followed by a 3%, 2%, and 1% prepayment penalty in each of the following years.

2)       Yield Maintenance – Typically found in conduit loans, the intent of yield maintenance is to replicate the cash flows that would be realized by the CMBS bondholders if the borrower had held the loan to maturity.  The yield maintenance calculation is more complex and dynamic than the previous example due to the constant fluctuation in market interest rates.  Typically, the yield maintenance penalty is calculated by taking the present value of remaining payments multiplied by the difference between the interest rate on the loan and a pre-specified index rate (i.e. 10-year U.S. Treasury Note).

It should be noted that yield maintenance is typically subject to a minimum fee equal to 1% to 3% of the remaining principal balance.  So even in an environment in which the index rate is greater than or equal to the interest rate on the loan, the borrower would still incur a yield maintenance penalty.

3)       Defeasance – Similar to yield maintenance, defeasance is typically found in conduit loans with the intent of replicating the CMBS bondholder’s cash flows.  However, whereas yield maintenance is the prepayment of the loan, defeasance is actually a substitution of collateral.  The original collateral (the real estate and associated cash flows) is substituted with a portfolio of U.S. Treasury Notes designed to generate cash flows that match the loan obligations.  A “successor borrower” will take the place of the original borrower, and the lien on the original borrower’s property is released.

Also unlike yield maintenance, there is typically no minimum fee when defeasing a loan.  Therefore, in an environment where market interest rates are greater than the interest rate on the loan, the borrower could actually defease at a discount.  Finally, as the defeasance process requires many third parties, it is fairly fee-intensive with costs ranging from $50,000 to $100,000 depending on the loan’s size and complexity.

Clearly, paying off a loan prior to maturity comes with many tradeoffs and requires a comprehensive cost-benefit analysis.  Depending on a borrower’s unique capital requirements and risk aversion, prepaying a loan may be the prudent decision even if the cost of doing so may be significant.   At Metropolitan Capital Advisors, our Senior Directors have extensive experience in advising our clients on these matters and assisting them in crafting financing strategies specifically tailored to their unique situations.  If you are interested in exploring selling and/or refinancing prior to loan maturity, please fill out the form below to contact one of our Senior Directors.