You want to pre-pay your financial loan for your business is thriving and you don’t want to pay so much in interest anymore. Or, you want to refinance your CRE loan because currently the interest rates are low and you want to be one of those able to grab opportunities when they appear.
The problem is your commercial real estate loan has a restriction on prepayment, as all non-recourse loans have. The reason behind these prepayment restrictions is the locked in yield the investors in commercial mortgage backed securities (CMBS) receive.
Lenders use the following instruments to prevent pre-payment and/or preserve investor’s yield:
In case of a Defeasance restriction the borrower has to purchase US Treasury securities replicating the cash flow that will be lost by the lender as a result of this prepayment. The borrower will pay using this acquired assets instead of paying in cash. By performing this asset exchange the investors will get their expected profit throughout the life of the loan. Add to this the fact that investors will not have to find new borrowers to replace the prepaid capital and you will understand the benefits for the lender in case of Defeasance.
The process takes 30 to 45 days and involves several outside parties such as lawyers and accountants, so don’t forget to add to the cost of prepayment, beyond the purchased securities, all fees requested by the outside parties, including the emergency fees, if you want to expedite the process.
Yield Maintenance (YM) clause requires the borrower to cover, when pre-paying a CRE, the remaining principal and in addition the present value of the remaining interest. The formula used is YM = Present Value of Remaining Payments x (Bond Interest Rate – Rate on a Treasury Note for bonds of the same duration as the mortgage in question. The yield maintenance prepayment clause usually makes prepayment unappealing for borrowers.
Another instrument lenders use to discourage prepayment is a fixed percentage of the remaining balance of the loan per year that depreciates as the number of the remaining payments reduces. To calculate the total penalty, you have to multiply the outstanding debt by the current penalty amount. Your statement at closing will cover all these amounts.
A prepayment lockout is a restriction included into your CRE loan agreement to simply prevent the prepayment of the loan. Most commercial real estate loans have a lockout of several years in which you, the borrower, are not allowed to prepay the entire loan. The prepayment lockout is usually combined with a defeasance restriction, a yield maintenance clause or a fixed penalty clause to ensure, as described above, the promised yield for the CMBS investors.