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.
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.
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.
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.