Prepayment Risk in Commercial Real Estate
Prepayment risk refers to the risk a lender faces if a borrower prepays a loan before it is scheduled to mature.Better Financing Starts with More Options$1.2M offered by a Bank at 6.0%$2M offered by an Agency at 5.6%$1M offered by a Credit Union at 5.1%Click Here to Get Quotes
When a borrower takes out a loan to purchase commercial real estate, they typically agree to make fixed payments over a set period of time. However, there is always the possibility that the loan will be paid off early. Prepayment of a commercial loan can occur for a number of reasons, including a change in the borrower's financial circumstances, or a refinance or sale of the collateral property.
While paying off a commercial debt early may seem like a good thing, the truth is that prepayment can actually create some challenges for both borrower and lender — and to the latter, this is what is known as prepayment risk.
What is Prepayment Risk?
Regardless of why a commercial mortgage is paid off early, both lenders and borrowers must consider the repercussions of loan prepayment. For a borrower, prepayment can appear to be a good thing because it means no longer having debt to worry about. However, for the lender, prepayment can be costly.
In fact, borrowers paying their loans off too early has a significant impact on business, which is why lenders view it as a risk. After all, the lender is denied their expected interest payments when the loan is paid in full before reaching its maturity date — and the interest on a loan is a lender’s key form of compensation. This can be a significant amount of money, especially if the loan was for a large amount and had a long term.
How Does Prepayment Risk Affect Commercial Mortgage Borrowers?
Because of the risk of losing interest payments that lenders face from prepayment, the industry quickly adopted a few risk mitigation strategies like lockout periods — where the loan cannot be prepaid until a specified amount of time has passed — to prevent those losses without forcing borrowers to be locked into a lengthy term. Additionally, in most cases, these risk mitigation strategies involve prepayment penalties inserted into commercial mortgage contracts.
When a borrower chooses to prepay a commercial debt with one such penalty, they are effectively required to compensate the lender for the missed interest payments in one way or another. Depending on the risk mitigation technique employed, borrowers may find it time-consuming and/or costly when exiting a commercial mortgage early.
A lockout period is a specified length of time during which a borrower is not allowed to refinance or prepay their mortgage. Typically, during this time, the borrower must make all payments on time and cannot default on the loan. If the borrower does default, the lender can foreclose on the property.
Commercial mortgage loans typically have a lockout period of five years or more. Lockouts protect the lender from having to worry about the borrower refinancing the loan and taking advantage of lower interest rates. It also allows the lender to recoup some of their losses if the property value decreases.
Prepayment penalties often exist as a fee that borrowers have to pay if they want to prepay their loans. Often, the cost of the fee will depend on the terms of the loan, and can sometimes be a significant amount of money. Beyond charging a simple or flat fee as a penalty, there are also more complex forms of prepayment penalties that are aimed at giving the lender a more fair return should the debt be paid off before fully maturing.
While there are many different options and configurations to prepayment penalties, in most commercial real estate deals, lenders opt to implement one of three common strategies – defeasance, yield maintenance, and graduated or “step-down” prepayment.
One way that lenders choose to protect themselves from prepayment risk is with a defeasance clause. In simple terms, this clause allows the borrower to pay off the loan early without technically having to “pay a prepayment penalty”. However, the process is no simple undertaking and involves multiple parties in order to execute.
With defeasance, the borrower must set aside money in an escrow account. This account —often held by a bank, trust company, or title company — is then used to make payments on the old loan as scheduled until it is paid off in full. In this way, defeasance isn’t a true prepayment of the debt, as the loan is still paid at the agreed intervals up to its maturity date, while the borrower becomes unencumbered by the debt. The process takes a good deal of work to get done right, however, and may be too long of a process for some borrowers.
Yield maintenance is another common way lenders address prepayment risk, though much simpler in execution. With yield maintenance, the borrower agrees to pay a premium if prepaying the loan. The value of the premium is usually a combination of a flat penalty fee added to the difference between the interest rate on the loan and the standing market rate up to the maturity date.
Yield maintenance can be a good thing or a bad thing, depending on the situation. A borrower can save money by prepaying a loan with a yield maintenance provision in a rising interest rate environment, though they would still need to factor in the cost of the premium before making the decision to prepay. In some cases, the amount can work against the borrower’s investment goals depending on the reasoning behind prepaying the loan.
Step-down prepayment is arguably the most reasonable prepayment risk mitigation strategy of the three, as it doesn’t particularly punish a borrower for paying their debt early. With step-down prepayment, the borrower agrees to pay a lower interest rate on the balance in order to prepay the loan. The caveat is that the premium amount depends on how far into the loan term the borrower is.
With graduated prepayment, the premium is larger at the beginning of the loan term, and typically reduces as the maturity date gets closer. There are often predetermined tiers that denote how much the premium will be to prepay the loan at any given period throughout the term. In most cases, step-down prepayment is implemented in tandem with a lockout period for the first few years of the loan term as further padding for the lender.
Prepayment risk is something that borrowers should be aware of when considering taking out a loan to purchase commercial real estate. There are a number of ways that lenders protect themselves from prepayment risks, such as originating a loan with a prepayment penalty or a lockout clause. Commercial borrowers should always try to determine the potential costs or rewards for prepaying their commercial loan.
If you would like to find out how you can get commercial financing with prepayment penalties that won’t hinder your future investment goals, fill in the form below. We’ll get in touch with a free quote.
What is pre-payment risk in commercial real estate?
Prepayment risk in commercial real estate is the risk that a borrower will pay off their loan before the maturity date, resulting in the lender not receiving their expected interest payments. This can be a significant amount of money, especially if the loan was for a large amount and had a long term. Lenders protect themselves from prepayment risks by originating a loan with a prepayment penalty or a lockout clause. Commercial borrowers should always try to determine the potential costs or rewards for prepaying their commercial loan.
For more information, please visit this page.
How can I mitigate pre-payment risk in commercial real estate?
You can mitigate pre-payment risk in commercial real estate by using risk mitigation strategies such as lockout periods or prepayment penalties. Lockout periods are when the loan cannot be prepaid until a specified amount of time has passed. Prepayment penalties are inserted into commercial mortgage contracts and require borrowers to compensate the lender for the missed interest payments when they choose to prepay a commercial debt.
For more information, you can read our article Understanding Prepayment Penalties.
What are the advantages and disadvantages of pre-payment risk in commercial real estate?
The advantages of prepayment risk in commercial real estate are that it can help borrowers save money by paying off their loan early. This can be beneficial if the borrower has the financial means to do so. Additionally, prepayment can help borrowers avoid the costs associated with a loan that has a long term and a large amount.
The disadvantages of prepayment risk in commercial real estate are that it can be costly for lenders. When a loan is paid off early, the lender is denied their expected interest payments, which can be a significant amount of money. Additionally, lenders may have to take on additional risk if they are unable to find a new borrower to replace the one that has prepaid their loan.
What are the common strategies for managing pre-payment risk in commercial real estate?
The three common strategies for managing pre-payment risk in commercial real estate are defeasance, yield maintenance, and graduated or “step-down” prepayment. Defeasance involves replacing the loan with a portfolio of government securities. Yield maintenance requires the borrower to pay a penalty to the lender in order to make up for the lost interest payments. Graduated or “step-down” prepayment involves a penalty that decreases over time.
For more information, please see Prepayment Risk in Commercial Real Estate and Understanding Prepayment Penalties.
What are the potential consequences of pre-payment risk in commercial real estate?
Prepayment risk can be costly for lenders, as they are denied their expected interest payments when the loan is paid in full before reaching its maturity date. This can be a significant amount of money, especially if the loan was for a large amount and had a long term. Commercial borrowers should always try to determine the potential costs or rewards for prepaying their commercial loan.
For more information, please refer to this article on Prepayment Risk in Commercial Real Estate.
How can I calculate the pre-payment risk in commercial real estate?
The best way to calculate the prepayment risk in commercial real estate is to consider the potential costs or rewards for prepaying the loan. This includes looking at the loan amount, the loan term, and the interest rate. Additionally, you should consider any prepayment penalty or lockout clause that may be included in the loan agreement.
For more information on prepayment risk in commercial real estate, you can check out this article from CommercialRealEstate.Loans.