There’s been quite a bit of discussion about the impending landslide of CMBS loans’ maturing in the next few years. However, this is not just a CMBS issue; it’s also true for multifamily loans from Freddie Mac and Fannie Mae. According to the Mortgage Bankers Association more than $275 billion of multifamily loans were made in 2005-2007, about 25 percent of which were Agency loans.
The vast majority of these were 10-year loans with either yield maintenance or defeasance prepayment penalties. Borrowers with these loans seem to feel trapped and frustrated with the inability to take advantage of today’s low rates due to the large prepayment premiums on their existing loans.
I have spent some time looking at this issue for number of clients, and while there is not a free lunch solution to this problem, there are some techniques that alleviate the pain of paying a large prepayment penalty. More importantly, these solutions make economic sense.
Today's 10-year treasury is hovering just over 2 percent. Compare this to the average 10-year treasury rate over the last 10 years of 3.31 percent, and the average over the last 20 years of 4.35 percent. While rates don't always return to their averages, this is a strong indication that today's rates are unusually low.
Experts certainly disagree on whether rates will rise, drop further or stay the same over the near future, but I think the odds are better that rates will be higher, not lower, two years from today. Whatever your opinion on rates, if your real estate strategy is a long-term hold, it is more important to protect yourself from the risk of higher rates than capturing the absolutely lowest rate.
In looking at loans maturing in late 2015 through 2018, the interest rates on these loans range from the high fives to the low sevens. With today's low rates this is resulting in prepayment penalties of 5 percent to 20 percent of current loan balance. This is quite high, and most borrowers believe this is unpalatable.
The only solution for truly reducing this prepayment penalty is time, and the main way most borrowers try to deal with this is issue is a forward-rate lock. Some lenders will allow you to lock your interest rate for a few months, maybe up to a year, allowing you to capture today's rate while prepaying your loan in the future when your prepayment premium is lower.
Life companies are great at this, but Freddie Mac and Fannie Mae also offer this option. With the relatively flat yield curve, a forward-rate lock is not very expensive. Based on recent quotes, a nine-month forward will cost about 30 bps more in rate, and a 12-month forward will cost about 45 basis points in additional rate.
This may seem high but, in transactions Pillar has been working on, the prepayment premium will be reduced by 20 percent to 60 percent by waiting an additional nine months before paying off the loan. Every deal is different, so make sure you run the numbers before making a decision.
Unfortunately, this strategy saddles you with the higher interest rate for the remaining term of the loan and only makes sense if you think the rate in nine or 12 months will increase more than the forward rate lock add-on. If you think rates in nine months will not increase by the 30 to 45 basis points of extra rate than the forward costs, you should just wait to prepay. Remember you are rolling the dice with respect to both rates and where lenders spreads and underwriting criteria will be when you decide to refinance.
Since a forward rate lock does not work for all loans or all situations, I have been recommending a different strategy to my borrowers who have a long-term hold strategy. This suggestion is to pay the penalty now, but take a new loan with interest-only (I/O) payments for a similar period to the remaining prepayment period. Since yield maintenance and defeasance prepayment penalties are basically methods to pass along the interest rate difference for the remaining term to the existing lender, an I/O loan allows you to recoup most of that cost over the same period, drastically reducing the effective cost of the early prepay.
The amount of the savings depends on your initial loan spread and the time to the end of the prepayment period, but, in the examples I have been working on, the savings are from 60 percent to 110 percent of the prepayment penalty. You also should remember that the payment of a prepayment penalty is an expense that reduces your income and, therefore, income taxes you pay. Taken together, the tax savings and lower payment makes paying a prepayment penalty much more palatable.
To see if you think this is a good strategy, you need to look at one other factor. What are your savings for the remaining term on today’s rate versus the future rate you might get? Assuming the prepayment date on your existing loan is two years out and that you will be getting a 10-year loan, you will capture that rate saving for eight years (years three through 10 of the new loan). If the rate when the prepayment expires in 2 years is 0.5 percent higher than today, you will be saving 4 percent of your loan amount in payments over the next 8 years.
Personally, I think this is a conservative assumption. If rates return to the recent 10-year average of 3.31 percent before you refinance the savings would be more than 10 percent. With today's low rates, many of Pillar’s customers are choosing a 15-year loan, making the savings over the loan term even higher.
The one issue with this strategy is that every loan cannot qualify for an interest-only option. This is especially true if you want cash out. However, lenders are aggressive today, and I would recommend you talk to your mortgage adviser to see if he or she can get you an interest-only loan to take advantage of this strategy.
Either of the strategies is a valid method to take advantage of today's low rates, if you believe, as I do, that rates will be higher in a few years. I strongly encourage any owner with a long-term hold strategy and with loans maturing through the end of 2018 to start looking at refinancing now.
Talk to your mortgage adviser about the opportunities today. You may choose not to do anything right away, but you will gain valuable information and be in a better position to take advantage of a new loan if interest rates start to increase earlier than you expect. If you are not sure who to speak to about this, please reach out to me, and I'll be happy to assist you.