Lessons Learned: Pondering the Prepayment Dilemma

Lessons Learned:  Pondering the Prepayment Dilemma

Mini-Storage Messenger – October 14, 2016

At first glance, it seems fairly obvious that with currently low interest rates and so many capital sources offering highly attractive loan options, now is a great time to obtain new financing for your self-storage property.

For many property owners, this obvious refinancing decision can get tricky because their current loans include a prepayment penalty for paying off a loan prior to maturity. So that raises the question of whether it is worth paying this penalty in order to capitalize on better loan terms.

Before answering that question, let’s take a brief market reality check. The majority of storage properties today are financed with fixed-rate loans featuring prepayment penalties for early payoffs. Banks typically provide these loans for three to five years with options to reset the interest rate thereafter. CMBS lenders have also been an attractive option for fixed-rate financing because many offer:

  • A low fixed rate for 10 years

  • Up to 75% loan-to-value ratios

  • 30-year amortization (sometimes beginning with an interest-only period)

  • Non-recourse, with standard carve-out exceptions

  • Cash-out allowances (loans in excess of current loan, and in many cases even more than the initial investment amount)

Most self-storage owners use bank financing which has a form of stepped prepayment penalties. A typical bank structure may be a five-year fixed rate loan with a declining annual prepayment penalty of 4%, 3%, 2% and 1% of the remaining balance, and no prepayment in the fifth year. CMBS loans will include a yield maintenance or defeasance calculation, and typically only allow a prepayment without penalty 90 days prior to maturity.

As owners get closer to loan maturity, they often wonder whether they should wait until then to refinance their property, or if they are better off biting the bullet, paying the prepayment penalty and receiving economic benefits that can include a return of equity and a new low interest rate.

Current Market Implications

Banks are marketing some of the most aggressive loan terms and programs I have seen in my twenty-plus years of securing storage property financing. In addition to tempting five-year financing terms, some banks are offering seven- and ten-year fixed rate options — all at likely lower rates than what you locked in three to five years ago during the economic recession.

Meanwhile, CMBS lenders are offering extremely low rates for non-recourse long-term fixed rate money. While ten years ago we all thought 5.5% fixed-rate financing was incredible, we are now securing ten-year fixed rate deals in the 4.5% range. In addition, credit unions have also jumped into storage lending with products that include fixed-rate full recourse financing with no prepayment penalties at attractive rates as well.

In addition to having access to attractive capital options, our industry as a whole is hitting on all cylinders with a majority of owners experiencing high occupancy levels and year-over-year net operating increases.

At some point though, the tides will turn and interest rates will move up, thus creating some market risk for storage owners. Despite an improving economy, the Fed has shown signs they will not start increasing rates until mid-2015.

However, there are other factors that affect bond and investment markets (and thus interest rates) that cannot be controlled by central banks, including global political uncertainties and unrest, such as the conflicts currently occurring in the Middle East, Ukraine and Iraq. Looking at recent history, interest rates often move with little prior notice, especially on more volatile increases or decreases.

Considering the Trade-Offs

This year, more of our storage clients are examining the cost benefit analysis of incurring an existing loan’s prepayment penalty and then proceeding along that front to secure new financing at lower rates. Many of them are even pulling equity out of their loans after paying the penalty cost.

Before you follow this path, you’ll need to consider several trade-offs.

First, look at how much time is left on your current loan before maturity. Most commonly, the prepayment penalty would need to be less than 5% to no more than 10% for prepayment to even be a viable option. That puts most prepayment candidates 12 to 18 months away from loan maturity.

Second, look at whether your operating income has grown since you last financed and if your current loan balance would result in a 65% or less loan-to-value ratio today. This is important because you want a new loan amount that is at least sufficient to cover the prepayment cost. Even if your income has not increased, your property value probably has gone up because cap rates are at historic lows and property valuations have risen. You may have a lot of “trapped equity” that can be redeployed. Oftentimes, prepayment penalty costs are much lower than paying equity investors for expansion, development, acquisition or other investments.

Next, by refinancing earlier, you reduce the risk of changing capital and/or bond markets which can create rises in spread or index rates and lead to higher interest rates. Clearly in today’s environment, there is much more room and risk for loan rates to rise rather than to fall further. Should interest rates rise, some loans may be constrained by debt service requirements and actual loan proceeds could also be reduced.

I frequently hear comments that if Treasury rates rise, then the defeasance or yield maintenance will decrease. This is a bit of a fallacy because as interest rates rise, shorter-term Treasury bonds move much less than longer term-bonds. The accompanying graph of historical Treasury bond rates illustrates this concept.

For example, if long-term rates rise 1%, the shorter Treasury bonds which are used for defeasance and yield maintenance calculations may rise .1%, thus having little impact on the total prepayment calculation.

Theoretically, if the 10-year Treasury bond increases 1% over a 12-month period, you will pay 1% more for the next ten years on a new loan than if you were to lock into a low fixed-rate loan today. In this scenario, the prepayment penalty cost would likely make sense.

A final tradeoff consideration is that the prepayment cost is also offset by the interest rate savings between your current loan and a new loan rate for the remaining term of your existing loan.

CMBS loan documents are all worded differently, but in general, a yield maintenance calculation compares the loan interest rate to the current Treasury or Treasury Swap rate applicable for the loan’s remaining months and pays the difference for each payment to maturity. In simple terms, let’s say you closed on a CMBS loan in 2005 for a 5.5% fixed rate and have 12 months before maturity. Looking at the 12-month Treasury which at the time of this article was .11% your penalty would be 5.39% of the remaining balance (calculated by subtracting .11% from 5.5%). While you should check your loan documents’ specific language, this example gives you an idea of what you might expect. In a nutshell, since short-term Treasuries are so low now, you can almost take your remaining interest payments through maturity to get a solid approximation of the penalty.

The defeasance formula is more complicated because in order to defease, you must actually buy bonds which will mature and then pay the equal payments of your interest and principal through maturity. Firms such as Defease with Ease and AST Defeasance Holdings are firms available to be contracted to administer and manage all requirements of a defeasance transaction. You will incur a penalty which is the difference in what you pay for the bond purchase and your remaining payments, which again is almost equal to the total interest payments to maturity on your current loan. Further, you’ll incur third-party expenses which could add another $50,000 to the total transactional cost.

As noted earlier, bank prepayment penalties are often structured in a stepped down manner. Occasionally, they have an index maintenance in which you compare the rate of the index at the time of the loan versus that same index’s current rate. In either case, the prepayment penalty is easy to calculate.

Taking the Right Step

Many owners have maturing loans coming due in 2015 and 2016. If prepayment costs become more viable as you approach maturity, it may make sense to pay the penalty and take advantage of current interest rates and attractive loan options. Before you take any step though, be sure to obtain expert counsel on your current prepayment penalty costs and available financing programs.

With more than 20 years of experience as a national self-storage mortgage broker and advisor, Neal Gussis is a Principal at CCM Commercial Mortgage. In addition to providing loan brokerage 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 224-938-9419 or ngussis@CCMCommercialMortgage.com.