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Prepayment Penalties in Commercial Real Estate
In commercial real estate loans, a prepayment penalty is a fee charged to borrower if they attempt to repay their loan early. When a lender issues a loan, they typically want to lock in their profit for a certain amount of time, so the prepayment penalty is a way to compensate them for their financial loss if the loan is paid off early.
- What is a Prepayment Penalty in Commercial Real Estate?
- Step Downs vs. Soft Step Downs
- Using Defeasance to Pay Off Loans Early
- Other Loan Prepayment Considerations
- Lock Outs in Commercial Real Estate
- Assumable Loans and Prepayment Penalties
- Questions? Fill out the form below to speak with a commercial real estate loan specialist.
- Related Questions
- Get Financing
What is a Prepayment Penalty in Commercial Real Estate?
In commercial real estate loans, a prepayment penalty is a fee charged to borrowers if they attempt to repay their loan early. When a lender issues a loan, they typically want to lock in their profit for a certain amount of time. Basically, the prepayment penalty is a way to compensate them for their financial loss if the loan is paid off early.
Step Downs vs. Soft Step Downs
After the lock out period (if there is one), a borrower can often pay off their loan for a certain percentage of the loan amount. If the percentage declines year by year, for example, 6% in the first year, 5% in the second year, 4% in the third year, and so on, this is called a step down prepayment penalty.
In comparison, some loans have a soft step down prepayment penalty. These usually start lower and decline more slowly. For example, instead of the 6-5-4-3-2-1 step down in the example above, a loan might have a 4-3-3-2-2-1 soft step down penalty.
Using Defeasance to Pay Off Loans Early
Some commercial real estate loan types, such as CMBS loans and certain kinds of life company loans, may be much more difficult to get out of, since there is external pressure on the lender to provide a certain rate of return. For CMBS loans, the CMBS bondholders expect a certain, guaranteed return. Likewise, life insurance companies need to know they can pay policy beneficiaries the promised amounts on their life insurance policies.
If a borrower wants to get out of one of these loans, they will usually have to engage in a process called defeasance, in which they purchase government-backed securities, such as treasury bonds, in order to repay the loan and guarantee the lender a specific rate of return.
Other Loan Prepayment Considerations
Lock Outs in Commercial Real Estate
While most types of commercial real estate loans have prepayment penalties, many also have lock out periods-- a specific period of time in which a borrower cannot repay the loan, no matter what. Therefore, borrowers should be very careful when looking at commercial real estate loans with long lock out periods. In the end, it could be difficult to sell the property before the lock out period is over.
Assumable Loans and Prepayment Penalties
As previously mentioned, prepayment penalties on commercial real estate loans can be a big hassle if the borrower wishes to sell the property within a few years of purchasing it. That's why borrowers should check if a loan is assumable before making a final decision.
An assumable loan can typically be transferred to a new buyer (with the lender's approval) for a small fee. In some cases, a commercial property with an assumable loan may actually be easier to market. This is because the new owner may not have to go through as many hoops as they would to take out an entirely new commercial real estate loan.
Questions? Fill out the form below to speak with a commercial real estate loan specialist.
Related Questions
What is a prepayment penalty in commercial real estate?
In commercial real estate loans, a prepayment penalty is a fee charged to borrowers if they attempt to repay their loan early. When a lender issues a loan, they typically want to lock in their profit for a certain amount of time. Basically, the prepayment penalty is a way to compensate them for their financial loss if the loan is paid off early.
Other loan prepayment considerations include lock outs in commercial real estate. While most types of commercial real estate loans have prepayment penalties, many also have lock out periods-- a specific period of time in which a borrower cannot repay the loan, no matter what. Therefore, borrowers should be very careful when looking at commercial real estate loans with long lock out periods. In the end, it could be difficult to sell the property before the lock out period is over.
What are the different types of prepayment penalties?
The three main types of prepayment penalties are defeasance, yield maintenance, and step-down prepayment. Defeasance involves replacing the loan with a portfolio of government securities. Yield maintenance requires the borrower to pay a fee to the lender to make up for the lost interest. Step-down prepayment involves a declining payment schedule based on the remaining balance at prepayment and the amount of time since the loan closing or rate reset.
Learn more about Step-Down Prepayment.
How do prepayment penalties affect commercial real estate financing?
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.
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 here.
What are the advantages and disadvantages of prepayment penalties?
The advantages of prepayment penalties are that they help to ensure that the lender receives an adequate income from the loan, even if the borrower pays it off early. The disadvantage is that the borrower may have to pay a significant fee if they want to prepay their loan.
According to Commercial Real Estate Loans, there are three common strategies for prepayment penalties: 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 fee to the lender in order to make up for the lost interest. Step-down prepayment involves a penalty that decreases over time.
What are the legal implications of prepayment penalties?
Prepayment penalties are legal in most states, but the exact terms and conditions of the penalty will vary depending on the state and the loan agreement. In some states, prepayment penalties are limited to a certain percentage of the loan amount or a certain number of months of interest. In other states, prepayment penalties are prohibited altogether. It is important to check with your state's laws and regulations to ensure that any prepayment penalty you agree to is legal.
In addition, it is important to understand the terms of the loan agreement and the prepayment penalty before signing. Make sure you understand the implications of the penalty and that it is fair and reasonable. If you are unsure, it is best to consult with a lawyer or financial advisor.
How can I avoid prepayment penalties when financing commercial real estate?
The best way to avoid prepayment penalties when financing commercial real estate is to look for loans with shorter lock out periods. Lock out periods are a specific period of time in which a borrower cannot repay the loan, no matter what. Therefore, borrowers should be very careful when looking at commercial real estate loans with long lock out periods. In the end, it could be difficult to sell the property before the lock out period is over.
In addition, borrowers should also be aware of the different types of prepayment penalties that may exist. 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.