Prepayment Penalty
A fee charged by a lender for agreeing to allow a borrower to payoff a loan prior to the end of the contractual loan period. A prepayment penalty (i.e. prepayment fee) is meant to cover the cost to lender of a loan paid off prior to the agreed upon date, especially as it relate to the lender’s reinvestment cost and interest rate risk.
Common forms of prepayment penalty in commercial real estate include a percentage of outstanding loan balance, Defeasance, and Yield Maintenance.
Putting ‘Prepayment Penalty’ in Context
Case Scenario: Prairie Vault Self Storage, Oklahoma City, OK
Clearview Equity Partners, a real estate private equity firm, acquired Prairie Vault Self Storage, a well-located, stabilized self-storage facility in Oklahoma City, Oklahoma. The facility includes 75,000 square feet of rentable storage space across 500 units, with an average occupancy rate of 90%. The investment strategy was core-plus acquisition, as the property offered stable cash flows with some potential for operational improvements, including implementing dynamic pricing software.
Clearview financed the acquisition with a $5 million, 10-year fixed-rate loan at an interest rate of 4.5% from a commercial bank. However, three years into the loan term, Clearview was presented with an attractive opportunity to sell Prairie Vault for a substantial premium to a regional operator consolidating assets in the market. The sale would result in an IRR exceeding the firm’s initial projections and meet investor return goals.
The Prepayment Penalty
To proceed with the sale, Clearview needed to pay off the outstanding loan balance of $4.4 million. However, the loan agreement included a prepayment penalty in the form of a Yield Maintenance provision. This penalty compensates the lender for the reinvestment cost and interest rate risk of the early payoff, ensuring they can “maintain” the yield they would have earned had the loan gone to maturity.
The Yield Maintenance formula for this loan is:
- Prepayment Penalty = Present Value of (Remaining Loan Payments x (Coupon Rate – Treasury Yield))
The bank calculated the penalty as follows:
- The loan had 84 remaining monthly payments of $22,852 (principal + interest).
- The difference between the loan’s interest rate (4.5%) and the current Treasury yield (2%) was 2.5%.
- The present value of the payments discounted at 2% (Treasury yield) resulted in a prepayment penalty of $350,000.
Impact on the Transaction
Although the prepayment penalty increased the total cost of the transaction, the potential sale premium more than offset this expense. Clearview included the $350,000 penalty in their disposition underwriting and determined the deal remained highly accretive. The firm successfully negotiated the loan payoff with the lender and completed the sale, delivering strong returns to investors while navigating the complexities of early loan termination.
Key Takeaways
- Understand Loan Terms: Prepayment penalties can materially impact investment returns. Lenders often include Yield Maintenance, Defeasance, or fixed-percentage penalties in commercial real estate loans.
- Factor Penalties into Decision-Making: Analyze whether the financial benefits of early payoff outweigh the penalty costs.
- Strategic Negotiation: When selling assets mid-hold, carefully assess financing structures to minimize impacts on profitability.
Frequently Asked Questions about Prepayment Penalty in Commercial Real Estate
What is a prepayment penalty in commercial real estate?
A prepayment penalty is a fee charged by a lender when a borrower pays off a loan before the end of the agreed-upon loan term. It compensates the lender for reinvestment costs and interest rate risk. Common forms include fixed-percentage penalties, Yield Maintenance, and Defeasance.
Why do lenders charge a prepayment penalty?
Lenders charge prepayment penalties to offset the financial impact of early loan payoff, particularly their lost interest income and reinvestment risks. The penalty ensures they receive a return close to what they would have earned if the loan matured as scheduled.
What is Yield Maintenance and how is it calculated?
Yield Maintenance is a prepayment formula that calculates the present value of remaining loan payments, using the difference between the loan’s interest rate and the current Treasury yield. For example, in the Prairie Vault Self Storage case, the penalty was calculated as the present value of 84 remaining payments discounted at 2%, totaling $350,000.
How did the prepayment penalty affect the Prairie Vault Self Storage transaction?
Clearview Equity Partners incurred a $350,000 Yield Maintenance penalty to pay off the loan early. Despite the penalty, the sale proceeds exceeded projections and the deal remained accretive. The penalty was factored into the sale underwriting to assess overall profitability.
What are the common types of prepayment penalties in CRE?
The most common types are:
Fixed-percentage penalties (e.g., 1-5% of the outstanding balance)
Yield Maintenance (present value of interest rate differential)
Defeasance (replacing the loan with securities that match the payment stream)
How should investors manage prepayment penalties in underwriting?
Investors should understand the loan’s prepayment terms and model penalties into their disposition scenarios. This ensures accurate evaluation of exit strategies and avoids unexpected reductions in deal returns when planning early sale or refinancing.
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