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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2016

Chasing Profit in Payoffs

Keep your eye on the bottom line when deciding whether it make sense to pay off a mortgage

Chasing Profit in Payoffs

In times of expected interest rate hikes, savings may be within your clients’ grasp, if they refinance early.

With the Federal Reserve embarking on a policy of gradually increasing short-term interest rates, a sense of urgency has set in throughout the commercial real estate industry among borrowers who believe that the time to refinance or sell their properties is now.

Although much depends on the overall performance of the economy, Fed officials have indicated that they intend to raise rates by about 1 percentage point a year over the next three years. For many commercial real estate owners, that creates a strong incentive to prepay existing debt in order to lock in long-term fixed-rate financing while interest rates remain historically low.

Although prepayment costs, such as yield-maintenance penalties, have dev-eloped a negative connotation among owners and originators, paying them can actually be well worth it for many commercial property owners facing the prospect of refinancing interest-only loans. This is assuming that interest rates continue to climb, making it beneficial to absorb the prepayment penalty — as long as the cost of that fee is less than the cost of expected higher interest rates in a few months or years. Conversely, if borrowers or industry experts feel that interest rates, in fact, are not going to rise, but stay steady or even drop, then exercising the yield-maintenance penalty may not make financial sense.

Compensating lenders

Yield maintenance is the process of releasing a commercial property from a mortgage lien by effectively paying the lender all remaining interest on the loan at a present-value discount. Once a yield-maintenance penalty is paid, the lien is released from the real property, allowing the borrower to either refinance or sell their property free and clear.

Lenders charge the penalty to account for interest payments they lose when a loan is paid off early. The effect of the penalty payment is to allow the lender to book the same yield regardless of whether all the mortgage payments are made until maturity.

With yield-maintenance costs tied directly to Treasury rates — the lower the rates on Treasury bills, the higher prepayment costs — many owners have dismissed prepayment as impractical, especially those with several years remaining until loan maturity. Since 2008, yield-maintenance costs have ranged from 4 to 6 points per year remaining on the loan, leading many borrowers to sit on their loans, rather than sell or refinance. In a time of rising prepayment costs, however, the calculations are different. Borrowers with many years remaining on their loans can benefit from locking in current interest rates.

Calculating your options

To pay off or not to pay off

Following are two cost scenarios for paying off a $10 million loan originated in August 2007 with a 10-year term, 30-year amortization and 6 percent interest rate.

Wait until maturity — August 2017

  • Remaining interest: $700,000
  • New loan interest cost: $4.975 million, at 6.5 percent interest
  • Total cost: $5.675 million over 10 years

Pay off in April 2016

  • Yield-maintenance costs: $600,000
  • New loan interest cost: $4.66 million, at 5 percent interest
  • Total cost: $5.26 million over 10 years.

Analysis

  • The potential cost savings of paying off the loan early and refinancing is $415,000.

Let’s break it down by looking at how yield-maintenance penalties are calculated. Assume a borrower owes $10 million on an outstanding interest-only loan. In this case, say the borrower is two years into the term of the loan, with eight years remaining, and the current interest rate is 5 percent.

The 8-year Treasury rate is 2 percent, which means a difference of 3 percentage points between the interest rate of the loan and the interest paid on Treasury bills. Multiply that 3 percent by the remaining 8 years, and you get a 24 percent penalty owed on the loan. That 24 percent multiplied by the $10 million owed on the loan amounts to $2.4 million. That amount is then discounted back to its present value, so in our example the yield maintenance premium would be about $2.046 million.

Now consider a borrower who has a loan that was originated in August 2007 with an original principal balance of $10 million at a 6 percent interest rate, 30-year amortization and a payoff deadline of

August 2017. Although a decision to pay off the loan now and refinance at current rates comes with a price — a yield-maintenance cost of $600,000 — that penalty is outweighed by the cost of refinancing later at a higher interest rate.

Even in cases where it makes financial sense, borrowers or originators dealing with early payoffs and the resulting yield-maintenance costs should be prepared for complex lender red tape — including providing a significant advanced notice of the payoff and complying with strict rules related to the exact payoff date.

If you’re using a yield-maintenance consultant, that professional’s role should include three basic duties:

  • Negotiating the lowest possible penalty;
  • Communicating effectively with the loan servicer; and
  • Guaranteeing on-time closing.

The consultant’s primary service is to let owners and loan originators rest easy by guaranteeing all requirements have been met and also assuring that there are no potential last-second mistakes that can blow up a deal.

• • •

Even though prepayment penalties might still range from tens of thousands to tens of millions of dollars, many borrowers can actually save considerable amounts of money over the long term by paying yield-maintenance penalties today — rather than absorbing higher interest rates later.

For borrowers looking to take advantage of to-day’s historic low rates, prepayment presents the opportunity to avoid enduring future interest rates as high as 6 percent to 7.5 percent and, instead, lock in rates of 4 percent to 5 percent now. In many cases, prepaying today means negating interest rate risk at a minimal cost.


 


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