JF1905: Everything You Need to Know About Prepayment Penalties | Syndication School with Theo Hicks
As if the apartment syndication process wasn’t complicated enough, now you have to worry about prepayment penalties on the financing. Theo will cover how they work, what to look out for, and when it may make sense to bite the bullet and pay the penalties. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Theo Hicks: Hi, Best Ever listeners. Welcome to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks. Each week we air two apartment syndication school series on the best real estate investing advice ever show podcast. Each of these episodes focus on a specific aspect of the apartment syndication investment strategy.
For the majority of our previously aired series and episodes we offered a resource, a Power Point presentation template, an Excel calculator template, how-to PDF guides… Some sort of free resource for you to download, that accompanies those episodes and series. All these free documents and free Syndication School episodes can be found at SyndicationSchool.com.
This episode we are going to talk about pre-payment penalties, so everything you need to know about pre-payment penalties. We’re gonna talk about what pre-payment penalties are, and then the three main types of pre-payment penalties, and then how to think about which pre-payment penalty you want to actually get for your loans.
A pre-payment penalty is going to be a clause specified in your mortgage contract, stating that a financial penalty will be assessed against you, the borrower, if you either significantly pay down the principal on your loan, or if you pay off the entire loan for a specific period of time. What we’re saying, basically, is that yes, the lender may actually charge you a fee when you give them their money back, which may seem counter-intuitive, but from the perspective of a lender, when they’re underwriting a loan, when they are trying to determine how much money to loan to you, one of the factors that they take into account is the interest payments, so the interest they’re gonna make on your loan, so a 5% interest rate, 10% interest rate, 12% interest rate. That interest rate is based on the principal amount. The lower the principal, the interest rate will stay the same, but the amount of interest they make is reduced.
So if you pay off a large portion of that principle, or if you pay off all the principal and close out the loan, then the lender is no longer going to receive those interest payments. So the prepayment penalty is something that the lenders have that protects them against the financial loss of interest income that they would have otherwise been paid over time. So if a lender provides you with a ten-year loan, they are assuming they’re gonna make interests for ten years. If you pay the loan off after five years, then they’re only making interest for five years, which is why interest rates are different on five-year loans versus ten-year loans.
On a ten-year loan you are typically going to see a lower interest rate, because they’re making money over a longer period of time, whereas for the shorter loans you’re gonna see a much higher interest rate.
Typically, the pre-payment penalty is incurred if the borrower pays down the loan either entirely, or significantly, via a refinance or a sell, within 1-3 years, and sometimes up to five years… Again, depending on how long the loan actually is.
There’s actually three types of pre-payment penalties, there’s not just one type. So the lenders are able to get that interest money by charging these three different types of pre-payment penalties. The first category are soft and hard pre-payment penalties. The second is yield of maintenance, and the third is defeasances.
The first category, the hard and soft pre-payment penalties. A soft pre-payment penalty allows a borrower to sell their property at any time, without paying a fee. But a fee is incurred if the borrower decides to actually refinance. So that’s a soft. No fee if you sell, yes fee if you refinance.
A hard pre-payment penalty does not allow the borrower to sell or refinance without paying a fee. So the difference here is when they charge the pre-payment penalty. For the soft pre-payment penalty, if that’s a clause, then if you sell, you’re off the hook. If you refinance, you are not off the hook. For the hard, no matter what, if you sell or refinance, you are on the hook for paying a fee. Both soft and hard pre-payment penalties are either a percentage of the remaining loan balance or of the principal amount, so anywhere between 1% to 3% of the remaining principal balance that was paid off at sale, or refinance. It could be a fixed amount, that is stated from the get-go in your contract, or it could be a certain number of months’ worth of interest.
For example, it could be 80% of six months’ worth of interest if you were to refinance or sell early. Again, these are going to be stated in your contract, so you’re gonna wanna know what the soft or hard prepayment penalty clause is and what the terms are when you are actually in your due diligence phase… Because if you plan to sell or refinance before that clause expires, then you wanna make sure you’re taking that added cost into account when calculating your sales proceeds.
The second category is yield maintenance. Yield maintenance is a pre-payment penalty that allows the lender to attain the same yield as if the borrower made all scheduled interest payments up until the maturity of the loan date. If you remember, I said earlier, when a lender underwrites a loan for you, they do so with the expectation of receiving interest on that loan for whatever term they set. So they plan on received 5% interest for ten years. If you pre-pay that loan amount earlier than (in that example) ten years, a yield maintenance premium can be charged, which allows the lender to earn their originally-projected yield. The purpose of the yield maintenance pre-payment penalty is to protect the lender against falling interest rates. So the yield maintenance premium is going to be the difference between the amount of money the lender would have made from interest payments on the loan, and how much money they would make if they were to reinvest the remaining loan balance.
So it’s not like if you get a ten-year loan at a 5% interest, you sell after five years – you’re not gonna owe them five years’ worth of 5%, you’re gonna owe them five years’ worth of 5% minus whatever they could have gotten by reinvesting that principal into something else. Typically, that something else is going to be a U.S. Treasury bond. For example, if the borrower — if you repay the entire loan balance five years early, the yield maintenance would be the difference between five years’ worth of interest payments and the interest earned from a five-year U.S. Treasury bond.
So in order to determine what that would be, this is something you can estimate on your own. Obviously, five years from now the five-year U.S. Treasury bond might be a little bit different, but you can look at trends — you can just google “U.S. Treasury bonds” and see what the five-year rate is (interest rate) and find that difference to determine what your yield maintenance fee would actually be.
And then the third category is called defeasance. So rather than getting charged a pre-payment fee, the defeasance option allows the borrower to exchange another cash-flowing asset for the original collateral on the loan. Typically, defeasance only applies to commercial real estate loans, while the yield maintenance and the soft and hard pre-payment penalty could apply to any mortgage loan that you get.
This new collateral – it’s going to normally be a Treasury security – is usually much less risky than the original commercial real estate investment… So the lender is far better off because they received the same cashflow they would have received from the interest payments on the loan, and in return receive a much better risk-adjusted investment.
Basically, when you’re using a defeasance, you are exchanging for another cash-flowing asset, so you’re exchanging the original collateral on the loan for another cash-flowing asset, which allows the lender to continue to make money.
So which pre-payment penalty is best? When you’re in apartments, generally speaking there’s gonna be some sort of pre-payment penalty on your loan, unless you’re getting a bridge loan of some sorts. If you’re getting long-term debt, there’s going to be a pre-payment penalty.
Each pre-payment penalty has pros and cons to both you as a borrower, as well as to the lender. The best option is gonna depend on whatever your business plan is, and then the investor’s expectations on future interest rates. That second one comes with that defeasance.
So the benefit of having a pre-payment penalty clause to you as a borrower is that you can receive a lower interest rate, and get lower closing costs on a loan with a pre-payment penalty compared to a loan without a pre-payment penalty.
So as long as your project business plan, your projected hold period is longer than the pre-payment period, so one to five years – again this will be stated in the loan documents, so you’ll know upfront exactly when that pre-payment period ends, then you benefit from the lower upfront costs and ongoing costs, than having to worry about paying that fee on the back-end.
Of course, it gets a little bit trickier for you as a borrower if you’re getting a loan with a five-year pre-payment penalty clause and your business plan is to refinance after three years. More specifically, going into the three different categories, the hard and soft pre-payment penalty is gonna be based on the timing of a refinance or the sell, so it’s easier to calculate upfront.
If you secure a five-year loan with a pre-payment penalty during years one to three, then you should be able to calculate the pre-payment penalty if your plan is to sell during year two… So the fee would be, for example, 1%, or whatever percent that is stated in your loan documents, of the remaining loan balance… Or 80%, 70%, 90%, or whatever is specified in your loan documents, of 6 months, 10 months, 12 months – again, whatever is specified in your loan documents – worth of interest. So soft and hard are pretty easy.
The other two pre-payment categories are gonna be dependent on the interest rates at the time of sell or refinance, which is gonna require some level of speculation, some level of assumption on your part.
Generally, the yield maintenance premium and the defeasance fees are gonna be based on the U.S. Treasury rate, and the U.S. Treasury rate is based on the market interest rate. So as market interest rates go up, the cost to invest in U.S. Treasury bonds goes down, and vice-versa. There’s an inverse relationship there.
So if you have a yield maintenance pre-payment clause and the current interest rate is higher, once that pre-payment clause is triggered, if the current interest rate is higher than the loan interest rate, then the yield maintenance premium usually decreases to zero. But when the interest rates are rising, then U.S. Treasury bonds are cheaper, so the difference between the remaining interest rates and the cashflow from buying U.S. Treasury bonds or providing another mortgage loan is zero or a net gain to the lender.
So lenders will typically add a clause that if the yield maintenance is zero, then it’ll trigger a soft or hard pre-payment penalty. For example, the pre-payment penalty may be the greater of the yield maintenance or 1% of the remaining loan balance. So it’s either this, or that. “Yeah, sure, if we make money on the yield maintenance – great. But if we don’t, we’re still gonna charge you a 1% to 3% pre-payment fee.”
So if you feel as if the interest rates are going to rise, then selecting yield maintenance can be the cheaper option compared to the soft or hard pre-payment fees or defeasance payments.
Now, the defeasance fee is gonna be also based on the U.S. Treasury rate, but unlike yield maintenance, the borrower – you can technically make money with defeasance. So again, the relationship between the interest rates and the U.S. Treasury bonds still holds true here. So if interest rates on loans will rise to a rate greater than the loan’s interest rate – so 5% at closing, but then 7% at refinance or sale, then the U.S. Treasury bonds lose value and become cheaper, which means you (the borrower) are able to buy the required bonds based on the defeasance option for less than what it is required to pre-pay the loan, which means you make some cashflow.
On the other hand, if interest rates are falling, U.S. Treasury bonds gain in value, then the borrower has to pay an amount greater than the loan amount at pre-payment. So defeasance is a good option if you think interest rates are going up, or if you plan on selling your multifamily property early, and are worried about the potential increase in mortgage payments with some sort of floating rate loan. So you’re paying it off because you don’t want your interest rate to go higher and higher and be paying more and more money each month.
But the defeasance option is obviously very complicated, because you’re taking your principal and investing it in something else, and trying to figure out “Okay, well what difference could it be? Will I make money? Will I lose money? Is it gonna be cheaper? More expensive?” So whatever defeasance is used, you’re typically gonna wanna hire some sort of defeasance consultant, which obviously also increases the costs.
The last thing I wanna do is go over some common examples of pre-payment penalty structures. These are just gonna be ones for the common Fannie Mae and Freddie Mac loans, because again, you’re gonna see pre-payment penalties on these agency debts on these longer-term loans. You’re not really gonna see a pre-payment penalty on a bridge loan, because the lenders that are underwriting these bridge loans understand that you’re gonna be paying it off after a few years, which is why the interest rate and the closing costs are gonna be a little bit higher.
Let’s start with Fannie Mae. Fannie Mae states that for all of their loans, flexible pre-payment options are available, including yield maintenance and declining pre-payment premium. So declining pre-payment premium – also called graduated pre-payment premium for fixed rate loans, structured ARM loans and hybrid loans – means that the pre-payment percentage is higher year one, and then gradually reduces each year. For example, if you get a five-year fixed Fannie Mae loan, then the pre-payment penalty year one is 5%, 4% in year two, 3% in year three, 2% in year four, and 1% in year five. After that, there’s no pre-payment penalty.
For Freddie Mac things are a little bit different. For their fixed-rate conventional loan – regular fixed-rate loan – there’s yield maintenance until securitized, which means… Securitize is the financial practice of pulling various types of contractual debt and selling the related cashflows to third-party investors as securities. Basically, you’re gonna pay yield maintenance if you sell or refinance before the lender is able to securitize their loan, package it together and sell it off to a third-party. Then after that it’s followed by a two-year lock-out, and then there is defeasance after that. There is no pre-payment penalty premium for the final 90 days. If the loan is not securitized within the first year, then the yield maintenance applies until the final 90 days.
The yield maintenance without defeasance is available for these loans that are securitized at an additional cost.
For floating rate they have four pre-payment options. For option one, you’re locked out year one, and then a 1% pre-payment penalty thereafter. Locked out means they won’t allow you to sell or to refinance. Then after that there’s a one-year pre-payment penalty thereafter.
Another option is 3% pre-payment penalty year one, 2% year two, and 1% thereafter. Another option (3) is 5% year one, 4% year two, 3% year three, 2% year four, and 1% thereafter. Then option four, which is only available for their ten-year capped loan – capped interest rate – 7% year one, reduced by 1% each year. 1% in year seven and thereafter.
For each of those options you’re gonna get different loan terms. The more expensive the pre-payment penalty, the better initial terms you’re going to get.
And then also, for their moderate rehab loan, which is a float-to-float loan, there’s a 2% pre-payment premium during the interim phase. For their float-to-fixed loan there’s yield maintenance during the interim phase, and then the standard Freddie Mac pre-pay structures that we discussed before apply thereafter.
Overall, those are the three types of pre-payment penalties. Unless you’re getting a bridge loan, as I mentioned, you’re most likely going to have a pre-payment penalty for your loan, so make sure you know which pre-payment penalty you have. If you have an option to select between different options and what the benefits are of those and the costs of those are, and if there is a chance that you’re going to trigger a pre-payment penalty, make sure you’re taking that into account when you’re initially underwriting your deal… And you’re gonna take that into account in the closing costs at sale.
So if you are assuming a $100,000 closing cost at sale without a pre-payment penalty, then you’re gonna get returns of X, but if there is a pre-payment penalty, you’re gonna have a little bit lower returns. So when you’re evaluating whether to sell early or not, make sure you’re remembering to take into account these pre-payment penalties, because it might tell you that you need to wait to sell… Because once those pre-payment penalties go away in a year, then you’re gonna be able to return a significantly larger amount of money to your investors.
That concludes this episode. That should be everything that you need to know about pre-payment penalties. Until tomorrow, make sure you check out the other Syndication School series about the how-to’s of apartment syndications, and check out some of those free documents as well. Those are all available at SyndicationSchool.com.
Thank you for listening, and I will talk to you tomorrow.