If you are just making the transition from investing in residential properties to commercial or multifamily, you probably noticed that the standard loan programs and terms are quite different than what you have seen when financing your home or your 1-4 unit property(ies). There are several differences but one of them is the prepayment penalty. You may be wondering, how can I avoid this? The answer is, you may not be able to. Most commercial loan programs come with standard prepayment penalties. There are a *few* times you may be able to secure a loan without one, details to come on this later. But for the 98% of you who will ultimately need to select a program with a prepay, here is the 411 on all things prepayment penalty… Step Down PrepayMost conventional banks have this type of prepayment penalty structure. A step-down prepayment penalty is calculated as a percentage of the loan balance at the time of pay off. Let’s say that you get a loan with a 5-4-3-2-1 prepayment penalty. This means that if you pay off your loan in year 1, the penalty is 5% of the loan balance. If you pay off your loan in year 2, the penalty is 4% of the loan balance. If you pay off your loan in year 3, the penalty is 3% of the balance. And so on…you get the picture. Now, some lenders may have a bit of flexibility. This is where a broker can be handy but I’ll spare you the hard sell for now. 😊 You may be able to shorten the loan term in exchange for a more attractive prepayment penalty or perhaps negotiate a clause that allows you to pay down up to 20% of the balance before the prepayment penalty clause triggers. The beauty of commercial financing is that there is some flexibility. Yield MaintenanceThis structure is more common when you are looking at larger loans, typically $5,000,000 plus. Its not that you can’t get a $1,000,000 loan with yield maintenance, you most certainly can, its just that you can likely find more competitive terms with a more attractive prepayment penalty. Most conventional banks do not use this structure. This is typically a structure used for lenders other than banks. Personally, I advise my clients to avoid this structure if possible. I am all about flexibility and this structure is about as inflexible as you can get. So, back to the question, what the heck is yield maintenance?
In simple terms, a yield maintenance prepayment penalty is used to guarantee the lender a set rate of return on the loan, even if the loan is paid off early. The lender will calculate the penalty at the time the loan is paid off, or paid down, to determine how much, if any, additional funds the lender needs to make his investment whole.
If at the time the loan is paid off rates are higher, then there is little to no prepayment because the lender can go out to the market and lend the money at a higher rate of return.
On the flip side, if at the time of the prepayment rates are lower, you may end up paying a hefty fee because the lender will lose money re-lending to someone else at a lower interest rate. The “Yield Maintenance” prepayment penalty is the calculation of that lost income, which is a factor of the original rate, current market rates, and the remaining term of the loan.
Let’s look at an example: an investor borrows $1,000,000 at 5% for 10 years with a yield maintenance prepayment penalty. On year five he gets an amazing offer and decides to sell the property. The lender looks at the current market interest rates and determines that today’s interest rate on a similar 5-year loan (5 years because that is the remaining term of the loan) is 4%. The difference (AKA spread) is 1%. There are five years left on the loan, so the bank would collect a 5% prepayment penalty (1% spread times 5 years) or $50,000. Wow, that is painful! Now a step-down prepay isn’t looking so bad.
Take note that this is a very basic rundown of yield maintenance. Each lender varies in their calculation, some may have a minimum, some may use a different index, and so on…
So there you have it, these are the 2 most common types of prepayment penalties. I mentioned a little earlier that you may be able to avoid a prepayment penalty. Now this is somewhat unlikely so let’s not get our hopes up but I’m saying there’s a chance…So what’s all this one in a million talk you say? Well, most credit unions do not have prepayment penalties so there is a possibility you can obtain competitive financing with NO PREPAY! There is also private money – many of which come with standard prepays too – but they can be bought down or bought out.
I have one last little snippet of information – commercial loans are assumable. So if you are looking to sell your building, there is always a possibility to require the buyer to assume your loan. Of course this may limit your pool of buyers but that’s a whole other topic to dive into at another time.
This is A LOT of information and this only touches the surface of what terms may be different that your typical residential loan so if you have more questions, ask away! Of course I am always open to feedback and suggestions as well.