A look at three leading prepayment options

Q. What are the types of prepayment penalty options I will encounter when financing a commercial property?

A. A prepayment penalty is included in most commercial mortgage loans to assure the lender that the anticipated yield that the loan was priced for will be earned. The three prepayment options you will find most prevalent in the marketplace are:

• Set prepayment schedule: This prepayment option establishes the exact amount of the prepayment for any period during the term of the loan. It is usually offered by commercial banks, but sometimes through insurance and finance companies also.

The cost of the prepayment can be calculated when the loan is originated and is expressed as a percentage of the outstanding loan balance at the time of prepayment. Assuming a 10-year fixed-rate term loan, the set prepayment schedule might be a sliding scale starting at 5 percent and declining by 1 percent annually, remaining at 1 percent through the final year of the loan term. Using the loan amortization schedule, the outstanding balance at any given point can be calculated along with the respective prepayment penalty.

• Yield maintenance is a prepayment option that is predominantly used by lenders offering “conduit” loans that are converted into commercial mortgage-backed securities. This prepayment option also is gaining wider acceptance among commercial banks, insurance and finance companies.

Yield maintenance applies the theory of maintaining the loan yield upon prepayment by creating a mathematical formula to identify the amount of additional cash that must be added to the loan payoff amount and then invested through securities, to maintain the loan cash flow/yield as if the loan was still outstanding.

The formula is complex and subject to interpretation by different lenders. Loans requiring yield maintenance as a prepayment penalty derive the interest rate, by adding a “spread” to an index that is coterminous with the term of the loan being offered. In a period of low or declining long-term interest rates this prepayment option can be very expensive, because more cash (greater penalty) must be added to the loan balance being prepaid to maintain the loans yield. In a period of rising or high long-term interest rates the yield maintenance calculation may be as low as $0, but there is usually a 1 percent minimum penalty for the prepayment.

• Defeasance as a prepayment penalty option is generally required only by some conduit lenders. It applies the same concept as yield maintenance but requires the borrower to acquire the securities necessary to maintain the yield on the loan if prepaid.

Defeasance is defined as the substitution of other collateral for the real property collateral securing the loan and providing the same yield. The major difference between defeasance and yield maintenance is that the borrower must defease the loan, and therefore incur the costs of acquiring the substitute collateral. The yield maintenance prepayment option requires the lender or loan servicer to be responsible for acquiring the securities necessary to maintain the loan yield.

The defeasance fee for acquiring the necessary securities is generally the same for any size loan, and is currently a minimum of $60,000 on top of the yield maintenance cost. The defeasance fee is likely to become more competitive in the future. There is no minimum prepayment penalty for a defeased loan. In theory, during a period of high interest rates the cost to provide substitute collateral to meet the loan yield, could be less than the outstanding loan balance, and the defeasance fee could therefore be reduced by the arbitrage that is created.

No borrower wants to have a prepayment penalty tied to his or her loan, but all three prepayment options can be acceptable, depending on the goals of the investment. Very rarely would I recommend defeasance as an option if there is a choice.

David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at Commercialnotes@eatonpartners.com.