Commercial PrePayment Penalties

I was catching up in my reading over the weekend and came across an interesting article.

It detailed a bit about Pre-Pays in commercial lending.
In case you didn't know, a Pre-Payment Penalty is a regular feature in the commercial side.

There's plenty of shocking differences between residential and commercial.
How about a $5,000 appraisal fee?
How about no 30 year fixed loans?
How about having a prepayment penalty and a Lockout?

What might be ugly to the residential investor is commonplace in commercial.

Back to the article, it was in an industry trade magazine and really well written.
the article speaks to the loan officer but I think it reads well enough to the layman.

"Penalties' purpose

There are many variations of the prepayment-penalty formula, but the bottom line is that lenders require them to protect a return on their investment.

To make loans, lenders have overhead costs. They rely on sales representatives and an underwriting staff to ensure everything meets their qualifications before a dime is let out of their hands. These processes are costly. Lenders try to make up this deficit by charging lender points, prepayments or both.

There are several different prepayment structures. Once you understand the different types, you can better explain to your clients why lenders use them and how borrowers can benefit.

Flat rate

Flat-rate prepayment penalties are the easiest to explain and calculate. This type of prepayment penalty would read as follows: 5 percent of the remaining principal balance for the first five years of the loan term or 5 percent for five years.

Basically, if borrowers want to sell the property or pay off the loan in the first five years after closing, they will be required to pay an additional 5 percent on top of the principal balance. The rates and time periods vary between lenders and loan programs. At the end of the prepayment term, the loan can be paid with no penalty.

Declining-rate penalties

This structure is similar to the flat-rate penalty in length of time, but it differs in that the rate changes over time.

The lender front-loads the cost it has incurred and amortizes the charges as time progresses. A typical declining-prepayment penalty would be expressed as a 10-percent declining penalty for 10 years. So if the borrowers choose to pay off the loan the first year after closing, they will have to pay 10 percent of the principal balance, the second year they'd pay 9 percent and so forth.

Exit fee

This type of fee is used in many shorter-term deals. Essentially, it is a flat-rate prepayment with no time element.

If the deal includes a 3-percent exit fee, the borrower must pay the penalty when the loan is paid off, regardless of if it is the day after closing, the date of maturity or any time in between.

Yield maintenance and defeasance

With yield maintenance, the lender protects itself from losing the mortgage interest it was earning. This is designed to make the lender indifferent to when the borrower decides to pay off the loan.

A simple example of yield maintenance would be as follows. A borrower closes a 10-year loan at 5 percent and wishes to prepay the loan at the end of year five (when interest rates have dropped to 4 percent). Because the lender will reinvest the mortgage balance at 4 percent, it will lose 1 percent per year for the remaining five years of the mortgage life. To protect its return, the lender will require the borrower to pay the value of the 1 percent that the lender would have received if the loan were brought to term.

Conversely, if the borrower prepays after five years when interest rates are at 6 percent, the lender can reinvest the proceeds at a higher rate than it was earning on the mortgage. Hence, the lender will actually pay the borrower to prepay.

Treasury defeasance is a form of yield maintenance used for loans intended to be securities. With this type of defeasance, a borrower is required to purchase a financial instrument that will match the return of the bondholders. Defeasance has the same general outcome as yield maintenance.

Lockouts

A lockout ensures the lender's return by making it too painful for borrowers to pay off the loan in the short term. A two-year lockout means the borrowers would be required to pay all the interest that would have been collected up to the 24th month and pay an additional prepayment penalty.

Benefits

Although borrowers are not keen on prepayment formulas, these penalties allow lenders to offer rock-bottom interest rates. Without them, lenders would have to factor prepayments into their rates, and rates would be higher.

So how do you sell prepayments to your clients? First, identify which one will be used for their particular loan structure and inform them about it. This is not something you want borrowers to be surprised about at the last minute. Borrowers have been known to walk away from the closing table because they did not understand the ramifications or know that a prepayment penalty was part of the deal.

Next and most important, discuss the borrowers' expectation on holding the property. If they plan on holding it long term without any desire to sell or refinance, the prepayment is a moot point. Thus, getting the best rate possible with a prepayment has no downside."

If you got this far, congrats!
The last statement was the most important and applies to all real estate investing.
You need to have and to know your exit strategy.

For more information on Commercial Mortgages see our commercial website:
http://www.patagoniafinance.com/cindex.html