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FOUR TYPES of Prepayment Penalties & How to Negotiate Them - YouTube
Channel: Bulletproof Cashflow
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When you are working with a lender or broker
on a commercial loan, one item you will want
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to pay close attention to are prepayment penalties.
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Overlooking this would be an expensive mistake
if you want to shorten your refinance period
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or make a significant reduction to your loan
balance.
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For those that aren’t familiar, prepayment
penalties aren't seen in residential mortgages.
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These prepayment penalties are regularly seen
in the loans that many of you out there are
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making: commercial loans - loans for properties
with 5 or more units.
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Before we go into some of the fee and penalties,
let’s go into the “why”.
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The primary reason lenders charge a penalty
is to recoup the cost of the loan if there
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is a change to the payoff of the term.
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You will notice that banks won’t charge
you a higher interest rate or points as a
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hard money lender would.
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The penalty is in place so they can get that
money back if you terminate the loan earlier
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than expected, whether through a refinance
or just paying it off for the outstanding
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principal amount.
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A lender wants to keep a performing loan on
their books.
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When the loan is paid off early, it introduces
uncertainty to their forecasts.
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They put these fees in place to keep that
loan
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in place.
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There are four common prepayment penalty structures
for commercial real estate loans:
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1) Yield Maintenance
In this penalty structure the lender will
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charge you the interest as if you had made
the payments for the entire period to maturity.
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They will calculate the net present value
of the interest and hit you up for that amount
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at closing.
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This one is fairly common.
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2) Defeasance
This is primarily used by insurance companies;
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Basically, instead of paying cash to the lender,
this option allows you to exchange the note
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with another cash-flowing asset.
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If you are doing this, the new collateral
is usually much less risky than the original
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commercial real estate asset.
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There is a much longer explanation, but doing
all this is not easy or cheap.
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This is primarily seen if the loan has been
bundled with other loans and sold as debt
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security as a Commercial Mortgage-Backed Security
(CMBS).
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Chances are that you will not see this on
your loan docs.
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3) Step-down
This one is quite common and simple; In this
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case, the lender will put a prepayment fee
schedule in place that will decline over time.
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For example, in a 3-2-1 scenario, you would
pay 3% of the loan amount prepaid in Year
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1, 2% in Year 2 and 1% in Year 3.
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If you are doing a refinance with the lender
that has this provision, they will sometimes
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waive the penalty if you keep the loan with
them.
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Be sure to ask this upfront.
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4) Lockout
This one is rare to see; It doesn’t allow
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for any prepayment at all during a specified
period.
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Let’s say you have a 10-Year loan without
contractual ability to prepay, or a lockout,
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in the first 6 years of the loan.
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There will be no option to refinance or even
sell the property during that time.
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As you can imagine, this will not work for
us in the world of commercial real estate.
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Avoid the lockout provision.
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There are many lenders with good rates and
no prepayment penalties.
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You will see this with lenders that offer
a floating rate loan.
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Depending on where we are in the economic
cycle, you may be comfortable with this.
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Personally, I like to fix my rate so I know
what to expect out of the monthly payment
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and know what my net operating income will
be.
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There is sometimes room for negotiating the
penalty.
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When you are presented with a term sheet,
review it closely.
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Have your partners take a look as well and
look for any prepayment penalties.
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If you need flexibility because of the deal
you are working on - for example, a 3-Year
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refi and distribution to your investors - then
a 5-Year step-down won’t work for you unless
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you are prepared to pay.
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Telling the lender what your plan is important.
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You can push for the prepayment you can commit
to by swapping it for another penalty type.
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Perhaps you would be fine with a 3-Year Yield
Maintenance and sell at the beginning of Year
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4.
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Or, they may even eliminate the entire prepayment
altogether by bumping the rate up a little.
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This may actually be a better choice for you
depending on your plan with the property.
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Lenders like to mitigate risk whenever they
can.
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By offering a prepayment mechanism that suits
your needs, they are more likely to accept
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and help you get this deal closed.
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Anyway, have you ever been hit with prepayment
fees?
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Have you heard of the ones I spoke about today?
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Let me know in the comments.
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I’d love to hear from you.
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If you liked this content, go ahead and give
it a thumbs up and share it.
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Also, check out the Bulletproof Cashflow podcast
on iTunes or Stitcher, and subscribe to our
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YouTube channel.
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We are working on getting new content out
all the time to help you build your success
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in the world of multifamily.
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Be great.
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