Mini-Storage Messenger – February 15, 2017
We all have been in various situations where we have been in a bit of a winning position, and have had the chance to quit while we’re ahead. Whether it’s having more chips than you started with in a friendly (or not so friendly) poker game, a stock pick who’s price has moved nicely above your purchase price, or even an argument with a friend or loved one in which the other side has slowly conceded their position. When is enough, enough? When do you continue pushing on, with the risk of ending up in a losing situation at the end of the day? That is a personal choice each of us has to make over and over throughout a lifetime.
The idea of taking some of your winnings off of the table while you’re ahead is a discussion we have with our commercial mortgage clients almost every day. Timing the market is a very difficult thing to do, and most investment experts believe that trying to time the market is a losing proposition over the long haul. Just like the story of the Tortoise and the Hare, slow and steady usually wins the race. If you’re ahead, often times it makes sense to take some of your winnings “off of the table” while you still can.
Unless you have been holed up in a cave for the past few years (without your smartphone), most of us understand that we are currently in an extremely low interest rate environment. How long can it last? Whether it’s refinancing your home or refinancing your self-storage facility, most would agree that now would seem to be the right time to refinance, if you haven’t done so already. “What do you think interest rates are going to do?” is a question that I often get asked. My answer is pretty consistent: Because current interest rates are at historic low levels, there is not much room for them to go down materially further — so the likely direction for interest rates is upward. I am sure that you can guess the follow-up question: “When will rates go up? …and by how much?” I don’t pretend to know the answer to those questions. You can read the Wall Street Journal, watch the 24/7 business news channels, or surf the web indefinitely looking for that answer from the “experts”. While experts are paid for their “expertise”, the truth is that nobody knows for sure exactly when interest rates will rise or by how much. If the experts knew for sure, they would all be extremely wealthy and long retired by now.
So now is the time to refinance…or is it? While we can refinance our homes at almost any time with no downside or penalty, it is not typically the case with commercial real estate loans. Unlike virtually all residential mortgages, which can be prepaid at any time with no penalty, commercial mortgages very often have prepayment penalties for paying the loan off before it has reached its maturity date. This is especially true with longer term, fixed rate loans, and is most onerous in the early years of the loan term. Many borrowers locked in a long-term fixed rate for seven, ten years, or even longer. However, now that rates are at historic lows, those borrowers would like to refinance today, even though their current loan hasn’t fully reached maturity. Many hesitate because their loans have a prepayment penalty. However, just because a prepayment penalty or premium may come into play, it does not necessarily mean that refinancing before the current loan matures is not a good idea.
Step-down Prepayment Penalty
Many fixed rate bank loans are 3 to 5 years in term and have a simple “step-down” prepayment penalty calculation. For example, a prepayment penalty for a 5-year fixed rate loan may be 4% in year one, 3% in year two, 2% in year three, 1% in year four and then 0% in the last year of the loan. These penalty amounts are calculated by multiplying the prepayment penalty percentage by the outstanding balance of the loan at the time of prepayment. This is very easy to calculate and become less onerous as the loan moves closer to maturity. It is also rather straight-forward when making a refinance decision in these cases. For example, if the existing interest rate on my loan is 5%, and I can refinance today for 4%, even though I am only in year four my current five-year loan, I may seriously consider refinancing in spite of a penalty. In the step-down example above, I would have a 1% prepayment penalty in year four. However, that 1% penalty will be recovered in the first year of my new loan in the way of interest rate savings, as my new rate of 4% is 1% lower than my old rate of 5%. So my decision now shifts to: “Do I wait for my prepayment penalty to burn off (go to 0%) and hope rates stay low until that time? Or… do I take a bird-in-the-hand approach and pay my prepayment penalty now and lock in a sure thing at 4% for the long term”?
Yield Maintenance and Treasury Defeasance
There are two other common types of prepayment penalty (sometimes called “prepayment premium”) calculations which are associated with fixed rate commercial mortgages. These are: (1) yield maintenance and (2) treasury defeasance, and are most often associated with securitized loans having long term, fixed rates for 10 years. After loan origination, these loans are securitized/sold into the secondary capital markets to investors who are purchasing security instruments based upon the loan’s mortgage rate and its 10-year maturity.
Because securitized loan is purchased at a price based upon the loan’s interest rate (which determines the investment yield) and the loan term (which determines the investment duration), if the loan were to prepay before maturity, the investors who purchased them must somehow be “made whole” on their investment. Said another way, these prepayment penalties are designed to allow the investor to attain the same yield as if the borrower had made all scheduled loan payments until maturity. In a low interest rate environment, as we have today, these prepayment penalties can be substantial, but are driven primarily by: (1) the loan interest rate and (2) the remaining term of the loan at the time of prepayment.
In the case of yield maintenance, the calculation can be mathematically complicated, but conceptually is very straight forward. For example, if the loan prepays two years before its maturity, the prepayment penalty is designed to be an amount that would allow the purchaser of the loan to take the outstanding loan balance/payoff proceeds and reinvest in U.S. Treasury securities which would create the same yield as the underlying mortgage for the remaining two years of the loan term.
Treasury defeasance takes the yield maintenance concept one step further. Instead of calculating an amount that would allow the investor to replace the underlying mortgage with like-rate and like-term U.S. Treasury securities, treasury defeasance requires that the underlying loan actually be replaced with like-rate (yield) and like-term securities. The economics of treasury defeasance and yield maintenance are similar, but with treasury defeasance there are additional transaction costs associated with engaging a securities firm (and several other parties to the defeasance process) to structure a “bundle” of U.S. Treasury securities that take the place of the underlying loan and will create the same payments as the underlying loan would have through its maturity, had it not prepaid.
Yield maintenance and treasury defeasance prepayment penalties, while somewhat complex, can be easily estimated by a qualified commercial mortgage broker or a defeasance consultant. However, after determining what that prepayment penalty is, the borrower is left with the same decision as in the step-down prepayment penalty example above: “Do I wait for my prepayment penalty to burn off (go to 0%) and hope rates stay low until then? Or… do I take a bird-in-the-hand approach and pay my prepayment penalty now and lock in a sure thing at today’s low rates”?
More Than Just Rates
In addition to the break-even analysis used in the step-down prepayment penalty example above, other factors can come into play that may help determine the borrower’s course of action. In addition to today’s incredibly low interest rates, today’s self-storage property values are at what most would agree to be all-time highs – allowing owners to borrower higher amounts, without necessarily increasing leverage. So in addition to weighing the likelihood of rates staying low, a borrower also has to keep in mind that in the future, they may not be able to borrower as much money as they can in today’s low interest rate and high property value environment.
We have borrowers ask us every day as to what we think they should do. When deciding whether or not now is the right time to refinance, there is no one correct answer for all. Each borrower must decide for herself/himself.
— A bird in the hand is worth two in the bush… or is it???
With more than 20 years of commercial real estate finance experience as a lender, borrower and advisor, Steve Libert is a Principal at CCM Commercial Mortgage. In addition to providing loan advisory services for all commercial real estate types, he specializes in securing debt and equity financing for self-storage owners nationwide. Based in Chicago, he can be reached at 224-938-9430 or slibert@CCMCommercialMortgage.com.