Types of Prepayment Penalties in Commercial Real Estate Financing
Prepayment penalties are a standard feature of most fixed-rate commercial loans, and they can have a significant impact on the total cost of paying off a loan.
If you’re looking to finance a commercial property, here is a guide to the most common prepayment penalties associated with commercial loans.
What is a Commercial Loan Prepayment Penalty?
A prepayment penalty is an additional fee charged if the borrower pays the loan off prior to its maturity date. The purpose of the penalty is to protect the lender’s expected profit on the loan. Should a loan be paid off early and the lender not receive the full amount of interest scheduled to be collected during the loan term, this payment will make them whole.
Which Types of Commercial Loans Have Prepayment Penalties?
Prepayment penalties are common on most fixed-rate commercial real estate loans, including commercial mortgage-backed securities (CMBS) loans, conventional loans, HUD/FHA 223(f) multifamily loans, and many other types of commercial mortgages.
Floating-rate commercial real estate loans are less likely to have prepayment penalties.
Because there can be exceptions to these general rules, borrowers should always review the features of any commercial loan under consideration. If a loan has a prepayment penalty, the penalty’s fees and structure should be detailed in the term sheet.
When is a Prepayment Penalty Assessed?
If a commercial real estate loan has a prepayment penalty, it will be assessed at the time the loan is paid in full prior to maturity and within the prepayment penalty period. Most loans are typically repaid when a borrower decides to pay off the loan early, or when a property is sold. If a property’s loan isn’t assumable, the loan will have to be paid off — possibly within the prepayment penalty period — with the proceeds from the sale.
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What Types of Prepayment Penalties Do Commercial Loans Have?
Commercial real estate loans may have several different types of prepayment penalties. The most common are lockout, fixed, step-down, defeasance, and yield maintenance.
A lockout period occurs when a commercial real estate loan is not allowed to be repaid in full. The loan terms will not allow for prepayment in any form, and the borrower must wait until this period expires if they want to pay off the loan prior to maturity.
Since it’s impossible to pay off a loan during the lockout period, it’s not technically a prepayment penalty and borrowers are wise to give any lockout period careful consideration.
While lockout periods often can’t be avoided, taking out a loan that includes a lengthy lockout period can restrict a borrower’s future options relating to the property such as a sale or refinance.
Fixed Prepayment Penalties
A fixed prepayment penalty charges a set fee if a commercial loan is paid off prior to maturity and within the applicable time frame in which the penalty is in effect. This fee is typically structured as a percentage of the remaining loan balance.
For example, a loan might have a fixed prepayment penalty of 3%. In this situation, the borrower would have to pay back the remaining balance plus 3% of the same if they wanted to pay off the loan in full.
Because a fixed prepayment penalty is based in part on the loan’s outstanding balance, the penalty slowly decreases over time.
Step-Down Prepayment Penalties
A step-down prepayment penalty (declining prepayment penalty) charges a percentage of the remaining loan balance, much like a fixed penalty does. Rather than maintaining the fee at a set percentage for the entire duration of the penalty period, this penalty decreases the percentage over time. The term “step-down” comes from the reduction of the penalty in scheduled increments, usually 1% annually.
The HUD/FHA 223(f) multifamily commercial loan has a step-down structure which serves as a good example. These loans charge a 10% prepayment penalty in the first year, which is then reduced by 1% annually. Thus, there isn’t a prepayment penalty after the tenth year of the loan.
Sometimes commercial loans have a soft step-down prepayment structure. This works similar to a standard step-down, except the initial percentage is lower and decreases at a slower pace. For instance, a soft step-down penalty might start at 4% and decrease by 1% every two years.
A step-down prepayment penalty can be advantageous when a borrower expects to pay off a loan after a given amount of time. For example, if proceeds from the sale or refinance of another property might make it possible to pay off a loan in 10 years’ time, a 10-year step-down prepayment penalty could work well.
Yield Maintenance Prepayment Penalties
A yield maintenance prepayment penalty is calculated by solving for the present value of future interest the lender would’ve collected if the loan were carried through to the end of the prepayment penalty period. Since many factors can influence present value in relation to future value, this calculation is typically carried out by a lender who utilizes yield maintenance frequently.
Defeasance Prepayment Penalties
Defeasance utilizes government-backed securities (i.e. treasury bonds) to maintain an identical rate of return for the lender. The bond coupons replace the mortgage as collateral, allowing the lender to collect interest from the bonds rather than from the commercial loan. Treasury bonds are normally used because of the predictable nature of their coupon payments.
Defeasance is mainly used with commercial mortgage-backed securities (CMBS loans) and life insurance company loans. In these situations, defeasance allows the lenders to produce an identical expected rate of return.
Although it’s not typically an option, few borrowers elect to pay off their mortgage during the defeasance period. The process is complex, involving accountants, attorneys, and others, and is usually an expensive endeavor.
Can Commercial Loan Prepayment Penalties Be Negotiated?
Commercial loan prepayment penalties are often negotiable, at least to a certain extent. Depending on the situation, borrowers may be able to:
- Shorten the duration of a loan, thereby reducing the duration of a penalty
- Attain a smaller fixed or step-down penalty, often in exchange for a higher interest rate
- Secure an alternate form of prepayment penalty, which may be more economically beneficial.
- Assure the loan is assumable, which allows the transfer of property without paying off the original loan
The prepayment penalty is best negotiated after reviewing the term sheet in detail.
Recommended Reading: Guide To Commercial Real Estate Loans