Loan Prepayment Penalties

Today, we are talking about everyone’s favorite topic: loan prepayment penalties. The prepayment penalty is one of the most major terms factoring into the attractiveness of a given loan option and the overall business plan. As a simple example, if the business plan’s goal is to have a short-term hold, then a long-term loan with an expensive prepayment penalty is unlikely the best option. The most dramatic example of such a prepayment penalty is yield maintenance, which essentially puts the borrower on the hook for all scheduled interest payments on a net present value basis based on a prevailing discount rate. And yes, it is actually more complicated than it sounds.

An interesting point about yield maintenance is that its cost depends on the interest rate of the loan as well as prevailing interest rates at the time of prepayment. This means that if the loan carries an interest rate which is at 3% yet the market rate is 5%, the prepayment penalty will be minuscule compared to the cost if the analysis were done in reverse (5% interest rate on loan while market rate is 3%). Due to the recent and dramatic rise in interest rates, borrowers who took on debt with yield maintenance within the last few years have the opportunity to prepay their loans for nearly nothing. For this reason, savvy investors may have been more willing to take on yield maintenance debt in the past because they assumed rates would eventually move higher (however, this same rationale may not have shown up in their exit cap rate assumptions).

On the flip side, today may potentially be a very bad time to take on yield maintenance debt since interest rates are likely to be lower within the next two to five years. While this may not matter to investors who are looking to keep their loan in place until maturity, this could be highly undesirable for opportunistic investors interested in refinancing or selling within the next five years.

As a side point, while it is often possible to sell a property subject to a loan assumption, allowing the seller to avoid paying the yield maintenance penalty, this most often has a negative impact to the sales price since the in-place debt likely is lacking in leverage, interest-only period, and possibly an unattractive interest rate.

Because of the likely heightened cost associated with yield maintenance over the next few years or so, it is worthwhile to consider avoiding yield maintenance by using bank debt or opting for a step-down prepayment penalty in exchange for slightly higher interest rate on an agency loan.

Another reason to consider the importance of flexibility is the fact that deals are starting to get done and will likely continue to get done at better prices but with very conservative financing (financing is temporary, price is permanent). While your underwriting might say one thing, the likely outcome will be the opportunity to refinance into much more attractive debt in the medium term, rather than simply holding on to the low leverage, high-rate acquisition debt. However, refinancing may not be possible if the ideal prepayment penalty structure is not contemplated from the outset.

Pivoting the focus to underwriting, as you know, deals are extremely hard to make sense of today. With only marginal price reductions, it is nearly impossible to find the same “mid-teens” returns we’ve been seeking when dealing with much lower leverage and much higher interest rates, especially when such a scenario is modeled out over five years. As mentioned previously, the likelihood of enduring ~50% LTV for five years is very unlikely since the opportunity to re-lever should it present itself.

The challenge is to find a way to accurately underwrite acquisitions in today’s environment based on the prospects of prepayment penalties and refinancing. Prices are likely going to come down over the next year and multifamily fundamentals remain strong, but deals could be missed with too conservative underwriting that misses out on the potential upside of better debt in the future. At the same time, it is always frowned upon to make optimistic or any kind of refinance assumptions in one’s model.

An interesting solution we have come up with is to model out a three-year hold while still using 10-year fixed-rate agency financing with a step-down prepayment penalty or bank debt equivalent. The benefits of this are the fixed rate loan, long-term debt to eliminate near-term maturity risk, and the ability to sell or refinance in two to three years in the upside scenario that valuations and capital markets are strong in that time frame. Modeling out a three-year hold versus a five-year hold increases the projected returns (despite a higher prepayment penalty) while not getting too aggressive since we can remain conservative / consistent with our exit cap rate assumptions. Feel free to reach out if you have questions about the current market or would like to learn more about investing with us.