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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2005

The balancing act: Borrower interests meet lender interests in prepayment premiums

c_2005-06_Marguardt_spotThe loan process can generate excitement when sourcing a transaction, locating the appropriate funding source, negotiating sizing, executing a commitment and documenting a commercial-mortgage loan. Taking these into account, prepayment provisions might not be at the forefront of borrower or broker concerns.

A few years down the road, though — when economic conditions make refinancing attractive or a sale opportunity arises — the loan documents’ prepayment provision takes on a new significance. When the borrower wants to prepay, commercial-mortgage-loan servicers field many questions about prepayment terms in the borrower’s loan documents. A focus on the prepayment terms earlier in the process can alleviate anxiety and even conflicts during the prepayment itself.

Commercial-mortgage-loan documents generally are subject to some negotiation and variation. The degree depends on the borrower, collateral, lender/investor and specifics of the transaction. Negotiation, lack of industry-standard provisions and variances in lending programs result in loan terms that vary in more ways than many borrowers, lenders and investors know. Just as servicers are responsible for servicing the commercial-real-estate-mortgage loan as a whole, they are governed by the actual prepayment provisions of the loan documents. Premium-percentage amounts, yield-maintenance calculations and defeasance terms are set at loan closing along with interest rate, payment dates and other loan terms. The servicer prepares a prepayment statement, including the premium amount, based on requirements in the borrower’s loan documents.

Premium vs. penalty

Prepayment premiums are normal and customary in fixed-rate commercial-real-estate mortgage lending. Many mistake prepayment premiums with penalties, but they are not. In contrast, a prepayment premium reasonably compensates the lender or investor for the loss related to paying the commercial loan before the scheduled maturity.

Viewed in its proper light, a prepayment premium makes sense. The lender/investor makes funds available to a borrower at a fixed rate for an agreed term. In general, commercial loans do not provide lender/investors with the right to call the loan if it is in their economic interest to do so. Similarly, a borrower generally does not have an unfettered ability to break the contract simply because it would be good economically.

A prepayment premium is a “pay as you go” feature that balances the borrower’s desire to eliminate the debt with the lender/investor’s desire to receive the agreed cash flow. Circumstances change in the seven to 10 years of a typical commercial-mortgage loan. To provide borrowers with an ability to manage the real estate (for example, to sell or refinance the property), prepayment-premium clauses (in lieu of a pure prepayment prohibition) are common. They obligate borrowers to effectively pay a breakage or make-whole amount to the lender/investor.

In other words, when borrowers pay a prepayment premium, they buy the flexibility to pay off the loan prior to maturity. As is the case with other borrower-option loan features, such as assumption provisions, the prepayment premium is part of the loan terms that a borrower and lender agree upon at closing. The prepayment premium agreed upon in the loan documents is part of the economic value of the loan, as are the other loan terms.

Release provisions

Clauses effectively providing for prepayment of loans have evolved in the commercial-real-estate industry. The industry practice in commercial-mortgage lending is for loan terms to include provisions that allow the borrower certain rights as set forth or restricted by the borrower’s loan documents. The borrower gains control of clear title to the real estate, provided that the lender/investor’s economic interest in the loan is protected.

Questions regarding loan-document provisions that provide for prepayment aren’t generally about the existence of a premium amount or substitution of defeasance collateral. Instead, they arise from the language of the actual provision contained in the specific borrower’s loan documents.

These clauses can run the spectrum from a relatively simple fixed-percentage-of-principal calculation to yield maintenance to a defeasance option. A defeasance option is a collateral substitution rather than an actual loan payoff that leaves the note in place but substitutes treasury bills to secure the loan. This gives the borrower clear title to the real estate.

Of these types of provisions, yield maintenance tends to be found in commercial and multifamily loans funded by life companies, Fannie Mae, Freddie Mac and to a limited degree, CMBS conduit lenders. Predetermined set-percentage provisions primarily are seen in Ginnie Mae multifamily and nursing-home loans. Defeasance provisions are typical in loans pooled in commercial-mortgage-backed securities.

Let’s take a closer look at all three clauses.

Predetermined percentage

The predetermined-percentage premium is the simplest prepayment mechanism. Generally, it is associated with Ginnie Mae multifamily and nursing-home loans. The borrower is able to pay the loan in full prior to the maturity date, provided that the payoff accompanies an amount equal to the product of the set percentage and the loan balance. Usually, this follows a lockout period in which prepayment simply is not permitted at all. The set percentage usually decreases over time.

For example, a 10-year loan may have a four or five-year lockout and a fixed prepayment premium of 5 percent in the following year. It reduces by 1 percent each year until maturity, unless exhausted earlier.

The advantage of this prepayment mechanism is the simplicity of calculation. The disadvantage from the borrower’s and investor’s points of view is that the prepayment premium does not reflect the differential between the note rate and current-market conditions. The borrower is required to pay the set percentage despite the relationship of market rates to the note rate.

Yield maintenance

The yield-maintenance premium is more complex. Calculations as required in the mortgage-loan documents are performed to assess the loss the investor will incur as a result of the borrower’s decision to prepay the loan. In some cases, the calculation is coupled with a minimum set-percentage premium. This recognizes the softer costs that the investor will incur to reinvest the prepaid funds. The calculated amount, however, will vary depending on the characteristics of the loan and market conditions.

Although yield maintenance is widely used to balance borrower and lender/investor rights in the event of a prepayment, there is no standard provision recognized in the industry. The language contained in each set of loan documents governs the calculation of the premium due to the lender/investor. There is no industry-standard yield-maintenance clause, so it’s not unusual for premium calculations to vary among comparable loans.

Yield-maintenance calculations are designed to compensate the lender/investor for the loss of yield from the borrower’s decision to prepay the commercial-mortgage loan. The calculation generally includes a variety of factors, such as cash flows, discount rates, remaining terms and treasury rates.

For example, the interest rate on the loan being prepaid may be compared with a benchmark — typically, the market rate of U.S. Treasury securities. To the extent that the loan-interest rate is higher than the return on comparable-maturity U.S. Treasuries, a prepayment premium is due.

As is the case with the set-percentage method, the yield-maintenance premium allows the borrower flexibility in managing the property and compensates the investor for loss of the contracted cash flows. Yield-maintenance provisions begin with the need to balance competing borrower and investor needs. Like other loan-document terms, the actual requirements of the yield-maintenance provision may vary.

Once documented, however, the borrower expects to be able to prepay in accordance with loan-document terms. If the borrower exercises the right, the lender/investor has the expectation of receiving the premium calculated in accordance with the actual loan documents. The commercial-mortgage-loan servicer is bound, via the loan documents and the servicing agreement, to calculate the yield-maintenance premium according to the borrower’s loan documents. The actual yield-maintenance premium due is a function of the loan-document requirements, the characteristics of the loan and market conditions at the time of the prepayment.

Defeasance

Defeasance provisions also provide the borrower prepayment flexibility while protecting the investor’s right to the contracted cash flows. Referring to defeasance as a prepayment premium is a misnomer. A defeasance provision, in fact, allows for collateral substitution by the borrower — government securities are substituted for the real estate.

In this case, the borrower regains clear title to the real estate by substituting government securities that provide scheduled loan payments according to the mortgage terms and payoff funds at maturity. The lender/investor continues to receive the periodic payments required pursuant to the loan documents on accepted dates.

With a balloon loan, the defeasance collateral will provide for the balloon payment also as originally provided in the loan documents. No premium is paid with a defeasance loan, as the substituted collateral mimics the cash flows that the lender/investor would have received, had the borrower not exercised this right. But if treasury rates are lower than the note rate, the cost of the treasuries required to defease the loan will be greater than the unpaid principal balance. The borrower then could view the cost as a premium.

From the borrower’s perspective, defeasance, yield-maintenance and set-percentage methods of prepayment all provide a clear title to the real estate. For the lender/investor, however, the defeasance method maintains the payment schedule provided for in the loan documents. The lender/investor does not incur reinvestment risk as a result of the borrower’s action. Scheduled monthly payments in the amount provided for in the loan documents are paid via interest payments on the defeasance collateral. Payoff is made as scheduled via the redemption of the matured government securities. Defeasance allows borrowers flexibility to manage the real estate without resulting in an unanticipated reinvestment risk for the investor.

•  •  •

Provisions in commercial-loan documents allowing for release of the mortgaged real estate are designed to balance the interests of borrowers and lenders/investors. Not only do the mechanisms vary, but the actual language of the provisions may also vary among lenders or even between loans. Loan documents also can contain a combination of these mechanisms or layer them with lockout or floor provisions.

Prior to the execution of loan documents, review by the borrower’s accountants and counsel is critical. Understanding the loan terms, document provisions and the impact of market conditions on the provisions will allow borrowers and their advisers to better analyze economic opportunities that involve the need to prepay mortgage loans or provide for release of the real estate.


 


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