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Taking the Pain Out of Prepayment

One of the advantages of multifamily financing is the ability to get non-recourse loans with fixed interest rates for up to 5, 7, 10, 12, 15, or even 30 years.  Most investors are using Fannie Mae, Freddie Mac, or CMBS to achieve fixed interest rates throughout their hold period.  The disadvantage of these loan products is that they come with a sizeable prepayment penalty if paid off before the last 3-6 months of the loan term.  In this article, we are going to review 3 types of prepayment penalties: step-down, yield maintenance, and defeasance.  Each one of these we will review the calculation, typical loan type it is associated with, and an example of $3MM loan paid off in Year 5 of a 10 year loan.

Step Down Prepayment

Calculation: (Loan Amount) X (% based on loan year you pay off loan)

Very simple calculation and typically less expensive than yield maintenance or defeasance.  Typically your interest rate is higher with this type of prepayment (5-10 bps depending on the loan term).

Typical Loan types: Freddie small balance (5/4/3/2/1 on 5 year; 5/5/4/4/3/3/2/2/1/1 on 10 year) and bank loans (2/1/0 on 3 year fixed; 3/2/1/1/0 on 5 year fixed)

EXAMPLE:  $3MM loan paid off in Year 5 of a 10 year Freddie Small Balance loan would have a prepayment penalty of $90,000 (3% of loan amount).  

Yield Maintenance

Calculation: (Loan Amount) X (difference between interest rate on mortgage-yield of comparable US treasury based on loan maturity) X (present value factor)

Very complicated calculation.  Actual prepayment of the loan.  Determined by calculating the present value of the remaining loan payments, with a discount factor equal to the current yield on the US treasury that matures closest to the loan’s maturity date.  Only transaction fee is a small processing fee to the loan servicer.  Allows lender to make the same yield as if the borrower had made all scheduled mortgage payments until maturity.

Typical Loan types: Fannie Mae loans (Yield Maintenance until last 6 months of loan term)

EXAMPLE:  $3MM loan with fixed interest rate of 5.00% originated in 2011 paid off in Year 5 (2016) of a 10 year Fannie Mae loan would have a prepayment penalty of approximately $490,000 with limited transaction fees.  See example below:

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Calculation:  Very complicated calculation.  The borrower purchases a portfolio of government bonds as replacement collateral to secure the debt and to generate the cash flows required to meet the future obligations of the debt. The future obligations of the debt include both the remaining principal and future interest owed on the loan.  In addition to the cost of the government bonds, there is a transaction fee paid to several third parties (servicer processing and legal, securities intermediary, consultant for defeasance) to purchase the replacement collateral. 

Typical Loan types: CMBS loans

EXAMPLE:  $3MM loan with fixed interest rate of 5.00% originated in 2011 paid off in Year 5 (2016) of a 10 year CMBS loan would have a prepayment penalty of approximately $500,000 with transaction fees of $50,000 for a total cost of $550,000.  

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Most investors prefer non-recourse fixed rate debt, but it comes at a steep price when you do not hold the loan to maturity.  Some options available to minimize these prepayment penalties are to take on recourse debt (limited prepayment penalty if you sell the property or at worst it is a step down penalty) or float your interest rate.  The key is to understand your investment horizon so you can put on the most advantageous debt to meet your investment objectives.