How Do Pre-Payment Penalties Factor in on Your Loan Decision?

Question

Most investors I speak to focus on the interest rate and LTV (loan to value) when seeking a commercial loan. Unfortunately, many are not paying as much attention to the pre-payment penalties. In today's climate I know many value-add investors are avoiding bridge loans and seeking longer-term, fixed debt. How are you managing/negotiating the pre-payment terms in case you want to exit sooner?

If you are using bridge loans, how did the pre-payment penalties factor into your decision?

Paul B. · Answer

As an investor, I always liked to see long-term debt in a deal, as long as possible. I didn't think about pre-payment penalty. Now I am invested in a few deals where we could probably get a good sale price two years into a 12-year loan, but the yield maintenance will take a big bite out of our returns. The fact that interest rates have dropped lately means that the yield maintenance is even higher, plus the loan is less appealing for an assumption.

So I am starting to think maybe a slightly shorter loan term, say 8-10 years would be more appealing to me. I still want long term debt so we have flexibility in the event of a downturn. Plus, I think I think I'd take a higher interest rate to get a step-down prepayment instead of yield maintenance. I haven't run the numbers on any specific deal, but it sounds better on its face.

Mike Dymski · Answer

Some sponsors are using variable rate debt with a rate cap and trading prepayment penalty risk for interest rate risk (both are risks).

A case can be made for diversifying between fixed and variable rate debt (prepayment vs interest rate risk) across a portfolio.

Chris Grenzig · Answer

@John Casmon we've been going with step down agreements and paying a slightly higher interest rate, this makes prepayment penalties a known number (depending on the year) and makes our projections significantly more certain (on sale costs). We feel the couple of extra basis points are more than worth it and usually are much lower than what yield maintenance would be anyway.

Greg Scully · Answer

@John Casmon - We have a bridge loan with no prepayment penalties.  Shop around if you're finding that in the terms.

For fixed debt, we prefer step-down penalties over yield maintenance, community banks may negotiate on the pre-payment terms.

Karen Schimpf · Answer

@Greg Dickerson is correct, Bridge Financing doesn't have prepayment penalties.  Many investors are not aware that the very competitive rates with a 10-year fix or 20-year fix have yield maintenance penalties. If you are only planning on keeping a property for 5 years, this loan could be very costly to get out of.  You could ask for a step-down pre-pay which will mean a higher rate or switch to a 5 year fixed rate with a 5-year step-down.

Chris Grenzig · Answer

@John Casmon agreed unless you're investors understand, or you more focused on cash flow, or you're definitely not going to go significantly shorter than the term, or if you think rates are going to U-turn and increase substantially in 5 years, it could be an attractive assumption which then it doesn't matter. I know rates have just stalled and dropped, but no one 18-24 months ago was talking about cuts, it was only about continued hikes so it's not a crazy thought lol

Greg Dickerson · Answer

@John Casmon  generally when you do interest only bridge loans there are no prepayment penalties. Those are typically only a factor when placing longer-term, non-recourse or agency debt.

John Casmon · Answer

Yes, it's interesting because I know many operators who are preaching that you want to lock in terms in case it's difficult to refi in 2-3 years. People tend to forget that while interest rates were crazy low in 2009-2010, it was also difficult to qualify for a loan at that time. On the flip side, those pre-payment penalties can reach into the six-figure range so certainly something to factor in. The step-down pre-pay seems to be the most viable option if you're seeking a long-term loan with built-in flexibility.

John Casmon · Answer

@Chris Grenzig

Think that’s a smart approach. Going for the lowest rate alone is not the best strategy if you are not factoring in the pre-payment penalties.

John Casmon · Answer

Yes, I should have clarified. The question should have been are you deciding to do bridge loans because of the pre-payment penalties on the long-term debt.

How Do Pre-Payment Penalties Factor in on Your Loan Decision?

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