the cost of sale. Borrowers, therefore, need to understand the prepayment penalty options available and cal- culate the impact each will have on overall returns. TYPES OF PREPAYMENT PENALTIES The three most common prepay- ment penalties associated with these securitized loans are: 1 Step–down 2 Yield maintenance 3 Defeasance We won’t do a deep dive into the formulas for calculating each type. But knowing the general scope of each form of prepayment penalty will help you understand how the cost of sale can increase or decrease, depending on the specifics of the debt at the time of sale. NO. 1 Step-Down The step-down prepayment penalty is the simplest to calculate. It is just a percentage of the Unpaid Principal Balance (UPB) at the time of payoff. This percentage will typically decline every one or two years depending on the various lenders’ programs. A common starting point for most loan programs is 5% of the UPB in year one, and then the penalty declines from there. The decline schedule is often a function of the loan term. For instance, if you struc- ture a 10-year term, it is quite com- mon to see a prepayment penalty that starts at 5% and declines 1% every two years, eventually resting at 1% beginning in year 9. Once a borrower gets toward the end of the loan term, the prepay- ment penalty is typically not a major factor and the cost of a sale can
Because the asset is being sold and is no longer in place to gener- ate revenues to service the debt, the proceeds from the sale are used to purchase securities sufficient to generate a stream of income that will service the debt through the remaining defeasance period. A third party is used to “defease” the loan, and it is typically a higher cost transaction than yield main- tenance or a step-down prepay. If market conditions allow, the seller may benefit from the defeasance and participate in that arbitrage. Please note that this will be spelled out in the loan docs, and the lender will often secure the right to any profits generated above the debt service. You should be able to negotiate and participate in that benefit. STRATEGIES TO REDUCE THE IMPACT OF PREPAYMENT The expense associated with any of the above-mentioned prepayment penalties forces investors to pay close attention to their exit strategy and to determine which prepayment struc- ture provides the lowest cost to exit. The following strategies are com- monly used to reduce the impact of a prepayment penalty. 1 Plan your work and work your plan! In other words, choose a prepayment penalty that burns off close to or at the time you expect to sell or refinance out of the loan. Although this strat- egy may be cost prohibitive for an early sale, it makes sense for a long-term hold. 2 Consider a shorter fixed-rate period. Some lenders, such as Freddie Mac, offer a loan structure with a rate that is fixed for a specific period and
be absorbed without dramatically diminishing the returns. That said, each deal will have unique timing and pricing. NO. 2 YieldMaintenance The yield maintenance form of prepayment penalty is quite com- mon with both Fannie Mae and Fred- die Mac loans. Although the actual formula can be rather complicated, the premise of the penalty is in the name itself. You are agreeing to maintain the yield that you promised to the lender. So, for example, you sell your prop- erty with a $3 million UPB, so the lender receives $3 million payoff at closing. They will then invest those funds in an equivalent investment vehicle with the same maturity and earn as much interest as the current market will bear. Per your agreement, you will make up the difference between your note rate and the market yield at the time of payoff, essentially “maintain- ing the yield” you promised to your lender. The yield maintenance is in place until the open period, so you will need to maintain this margin for the bulk of the remaining term. You can see how this prepayment penalty could get extremely expen- sive, especially in a flat or declining rate environment where that mar- gin is greater. Even when rates are rising, they would need to increase at a healthy pace to offset the fact you are buying an investment vehicle with shorter maturity, which usually pays a lower yield. NO. 2 Defeasance Defeasance, another form of prepayment penalty, is most seen in conduit, or CMBS, loans. When a defeasance prepayment is executed, the debt is not retired or paid off. It is more of a substitution of collateral.
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