Making Prepayment Pay Off
- Mar 15, 2016
By Eitan Weinstock, Senior Analyst, Yield Maintenance Consultants
In December, the Federal Reserve raised interest rates by a quarter of a percentage point. This was the first increase in almost 10 years. Though a small increase, it caused many in the commercial real estate industry to decide that the time to refinance or sell is now. As the New York Times reported, “On the whole, Fed policy makers see four additional quarter-point increases in 2016.” For many commercial real estate owners, it makes sense to prepay existing debt in order to lock in long-term fixed-rate financing while interest rates remain low.
Although prepayment penalties such as yield maintenance carry a negative connotation among owners and brokers, paying them can actually be well worth it for most commercial property owners. Of course, that’s assuming that interest rates continue to climb.
Yield maintenance, most often used in commercial real estate as the prepayment requirement on life insurance company and agency loans, is the process of releasing a commercial property from the lien of the mortgage by effectively paying the lender all remaining interest on the loan, at a present value discount. Once a yield maintenance penalty is paid, the lien is released from the real property, allowing the borrower to simultaneously either refinance or sell their property free and clear.
If you use a yield maintenance consultant, they have three main responsibilities:
- Negotiate the lowest possible penalty.
- Interface with the loan servicer.
- Guarantee on-time closing.
Firms such as Yield Maintenance Consultants (YMC) are experts in properly structuring yield maintenance penalties to use the highest possible yields and utilize long-term relationships with servicers to navigate complex lender red tape. Most important, with yield maintenance penalties requiring significant notice and exact closing timelines, Yield Maintenance Consultants lets owners and brokers rest easy by guaranteeing that all requirements have been met and that there are no potential last-second mistakes that can blow up a deal.
With yield maintenance costs tied directly to Treasury rates (i.e., the lower the Treasury rates, the higher the prepayment costs), many owners have dismissed prepayment as impractical, especially those with several years remaining until loan maturity. Since 2008, yield maintenance costs have ranged from four to six points per year remaining on the loan, leading many borrowers to “sit” on their loans rather than sell or refinance. However, Moody’s reported a significant rise in yield maintenance payoffs in 2015, an increase of 140 percent from 2014. What’s more, 2015 data shows borrowers are paying off loans with longer remaining terms than in 2014. Even borrowers with many years remaining on their loans are taking the opportunity to further lock in low long-term interest rates.
While penalties still range from tens of thousands to tens of millions of dollars, many borrowers can actually save considerable amounts by paying yield maintenance penalties today. For borrowers looking to take advantage of today’s historic rates, prepayment presents the opportunity to avoid 5.5 to 7.5 percent rates in a year or two, and instead lock in 4 to 5 percent rates for a decade or more. In many cases, prepaying today means negating interest-rate risk at a minimal cost.
Take the example in the following table:
In this case, a borrower whose loan has an original principal balance of $10 million originated in June 2007 at a 6 percent interest rate has a potential cost savings from paying a yield maintenance penalty now of approximately $415,000, based on current interest-rate forecasts. As illustrated in the table, the total cost to prepay today will be approximately $600,000, while savings from locking in a new 10-year loan at 5 percent interest rather than 6.5 percent interest would be approximately $1.015 million, resulting in a net profit of $415,000. Should interest rates move above 6.5 percent, these costs will be even more significant.
To find out if now is the right time to pay off your loan, or for any other complimentary information on commercial loan prepayment, please contact Eitan at EWeinstock@YieldMain.com or (800) 754-9624. For a free calculation of your Yield Maintenance costs, visit YieldMain.com.