Prepayment Penalties Simplified

Demystifying Yield Maintenance, Defeasance and Other Prepayment Penalties

Understanding commercial real estate prepayment penalties can be confusing if you are not dealing
with them on a regular basis. Adding to the confusion, lenders refer to prepayment penalties in various ways – some call them “prepayment fees”, “unwinding costs”, “early termination fees”, “breakage costs”, “interest guarantees”, or “exit fees”, while others (insisting they are entitled to a long-term yield and perhaps not wanting to draw a negative connotation to the term) refer to them as “prepayment privileges”.

Most home loans do not have prepayment penalties because they are typically grouped together with hundreds (or even thousands) of other loans in a pool of mortgages (called an MBS pool), and the bond market can estimate with relative certainty how many loans in the pool will pay off early – thereby enabling it to quantify and price the risk. So why is the commercial world so different? Commercial real estate loans are much larger, are generally held in a lender’s portfolio, and the loss of a single loan can cause substantial financial harm to a lender (or investor, if not held on the lender’s books). Lenders demand prepayment penalties because just as you are making an investment, so are they. Lenders must match their assets (loans) to their liabilities (deposits, annuities, or borrowing costs). The following summary shows which prepayment penalties are typically associated with each class of lender:

Life Insurance Companies:PortfolioYield Maintenance
Banks:PortfolioStep-down
Agencies (FNMA/Freddie Mac):Sold as BondsYield Maintenance
Credit Unions (Federally-Chartered):PortfolioNone
Credit Unions (State-Chartered):PortfolioStep-down
CMBS:Sold as BondsDefeasance
Others (Debt Funds, Private Lenders,
Etc.)
PortfolioVaries widely but typically involves a “lock-out” period
which prohibits prepayment altogether for a certain period
in order to guaranty a minimum yield to the lender.

This is only a generalization and caution should be taken not to apply these prepayment penalties to every lender in each lender class, as some venture outside the box by offering one or more alternative prepayment structures. The following is an elementary explanation of each type of CRE prepayment penalty:

Yield Maintenance:

In simple terms, Yield Maintenance is designed to maintain the lender’s yield (or return on their investment) throughout the fixed rate period of the loan. Without diving into the specific mathematic equations of Yield Maintenance, here’s how it commonly works: If interest rates have stayed flat or declined since your loan closed, the lender receives compensation equal to the present value of the difference between a) the note rate, and b) the then-current yield on the US treasury bond which most closely matches the time until your loan matures (or your rate is reset). In other words, if you give the lender their money back prematurely, you will need to compensate them for the loss they will suffer by having to reinvest it in lower-yielding government bonds. If on the other hand interest rates have risen to such an extent which renders the Yield Maintenance penalty negative or negligible, a 1% minimum will usually be charged. If you are unsure how to calculate your Yield Maintenance prepayment penalty, please reach out to me at jeffc@jscoats.com and we will help you.

Positives
  1. In a rising rate environment, Yield Maintenance can decline to the 1% minimum, making it a very reasonable penalty, especially when compared to a Step-Down structure.
  2. A long term fixed rate loan which carries a Yield Maintenance provision (which is very common) could potentially increase the value of your property in a rising rate environment, provided the loan is assumable. In other words, when you sell your property a buyer would ostensibly pay more for your property, provided they can assume your low rate loan.
Negatives
  1. In a rising rate environment, Yield Maintenance can decline to the 1% minimum, making it a very reasonable penalty, especially when compared to a Step-Down structure.
  2. A long term fixed rate loan which carries a Yield Maintenance provision (which is very common) could potentially increase the value of your property in a rising rate environment, provided the loan is assumable. In other words, when you sell your property a buyer would ostensibly pay more for your property, provided they can assume your low rate loan.
  3. In a rising rate environment, Yield Maintenance can decline to the 1% minimum, making it a very reasonable penalty, especially when compared to a Step-Down structure. A long term fixed rate loan which carries a Yield Maintenance provision (which is very common) could potentially increase the value of your property in a rising rate environment, provided the loan is assumable. In other words, when you sell your property a buyer would ostensibly pay more for your property, provided they can assume your low rate loan.

Defeasance:

Defeasance loans are almost always tied to commercial mortgage-backed securities (CMBS) loans, which reside in large pools of loans backed by CMBS bonds. These bonds are sold on Wall Street to buyers who are promised a certain yield over the term of the bond issuance. The gross yield is equal to the cumulative interest generated from the entire pool of loans. So, when you pay off your CMBS loan early, it’s not so simple. “Defeasance” of your loan involves purchasing a US Government bond which produces income equal to the remaining interest payments on your loan, which effectively replaces the collateral in the pool (your property) with a bond. That’s why a mature CMBS bond pool will almost always include a mix of properties (deeds of trust) and several bonds (which have replaced those properties which have been paid off). In a way, the yield replacement feature of Defeasance is similar to Yield Maintenance in that the lender’s/investor’s yield is maintained.

Positives
  1. More impartial than Yield Maintenance in that it does not overcompensate the lender for a loan that is paid off in an increasing rate environment. The math is very pragmatic – it is what it is.
  2. In theory, it is possible to pay off your loan at a discount if rates rise enough (no 1% minimum).
  3. In rare circumstances “collateral substitution” might be a possible alternative to Defeasance if negotiated up front in your loan documents. This is where a different property (which must be free & clear) replaces the subject property in a pool. No prepayment penalty is incurred in this case.
Negatives
  1. Defeasance is costly as it must involve a cast of characters including attorneys, the loan servicer, a third-party Defeasance processor, and even bond rating agencies or CPA’s to execute the transaction.
  2. The actual cost of Defeasance is not determined until the day of payoff.

Step-Down:

A Step-Down prepayment penalty (aka: declining or fixed prepayment) is a predetermined, sliding scale based on the principal balance of the loan at the time of prepayment and the amount of time which has passed since the loan was closed or the rate was last reset.   For example, 5% of the then-outstanding balance in the first loan year, 4% in the second loan year, 3% in the third loan year, etc., or 3%, 1%, 1% for the first three years.

Positives
  1. Simple and straightforward (it is what it is).
  2. Predictable. You know up front what the prepayment penalty will be in any given year.
  3. A good option in declining or flat rate environments relative to Yield Maintenance or Defeasance.
Negatives
  1. Some 10 year fixed rates start off with a 10% prepayment penalty in the first loan year (albeit declining in subsequent years) making the prepayment penalty difficult to swallow in the early years of a 10-year loan. You might be better off with Yield Maintenance or Defeasance with a long term fixed rate (10 years or more), or if you believe rates will rise.
  2. This can be a poor choice in a rapidly rising rate environment.

Miscellaneous terms related to prepayment penalties:

Lock-Out:

The period, usually at the beginning of the loan, where you cannot pay the loan off at any cost.  At some point, it is not worth the lender’s time and effort to originate the loan if they are not assured that they loan will be on the books for a minimum amount of time, and therefore, some lenders insist on a Lock-Out period of 1 – 3 years depending upon the length of the fixed rate period.

Open Period:

This is the period at the end of the loan or fixed rate period when the loan can be paid off with no penalty.  This is usually 30 – 90 days which is ample time for a borrower to line up a new loan.

The summary above is written by Jeff Coats.  The views, thoughts, and opinions expressed herein belong exclusively to the author and are not necessarily those shared by all lenders or other mortgage bankers or brokers in the industry.  Mr. Coats is the owner of JS Coats Capital, LLC and has 30 years of experience in commercial real estate finance.