Why Are Pre-Payment Penalties Important in Commercial Real Estate Financing?

What is a pre-payment penalty?

When you pay the loan off early, there is a penalty that goes along with doing it. Typically, this penalty is on the commercial side of real estate.

Step Down

This one is straight forward in that the prepayment penalty drops down for a specific time frame. For instance, some loans will start at a 5% pre-payment penalty and drop down 1% per year. Other loans I’ve seen do this are some HUD loans. One HUD loan deal I invested in had a pre-payment penalty starting at 10%. Every 2 years, it dropped down 2%. The loan amortization and term is 35 years.

Yield Maintenance

This one is known to be the highest cost pre-payment penalty. That is only true if interest rates decrease and there’s excess time left on your loan term. For instance, say interest rates dropped from 8% to 6%. The lender would be making less money if they issued a new loan today at 6%. What they do is take the entire difference in their profit on a 6% loan vs 8% loan for the entire remainder of the loan term. I’ve heard of worst cases when the prepayment on a deal were around 20% of the loan amount.

1 Year

This is when you have a pre-payment penalty in the first year and after the first year, there is no penalty. This is a common structure in bridge loans. On bridge loans I typically see a 1% pre-payment penalty.

Fixed

This is when there is a fixed pre-payment penalty throughout the entire hold until the last year.

None

Some bank loans or bridge loans will charge no pre-payment penalty.

FAQ’s

Do you pay a pre-payment penalty when you make a sale and the buyer assumes your existing loan?

- No, it’s the same loan so the loan isn’t being paid off.

Should I match my pre-payment penalty to the projected hold period in my business plan?

I personally side on the longer term loans, even if the business plan is 3-5 years. I see having a short term loan (1-5 years) as a greater risk of the whole deals failure where having a long term loan may risk taking away a portion of the profit from a pre-payment penalty.

Which pre-payment penalty is best?

When you do larger loans through agency lenders (Fannie and Freddie) you’ll usually only get two options, step down or yield maintenance. You’ll be presented with a term sheet which explains the loans they can give you. This includes length of term, interest rate, pre-payment etc. I personally like the longer term loans (7 year minimum but ideally 10+ years) with a step down pre-payment penalty.