What it is
Most commercial real estate loans charge a cost if the borrower pays them off early. Lenders, and the investors who buy their loans, price loans expecting to collect interest for a certain period. A prepayment penalty compensates them if that interest stream ends early. For a sponsor who might sell or refinance before maturity, prepayment terms can matter as much as the rate.
Common types
Step-down
A fixed percentage of the outstanding balance that declines over time. A "5-4-3-2-1" structure charges 5% in year one, 4% in year two, and so on.
| Year of payoff | Penalty | On a $10,000,000 balance |
|---|---|---|
| 1 | 5% | $500,000 |
| 2 | 4% | $400,000 |
| 3 | 3% | $300,000 |
| 4 | 2% | $200,000 |
| 5 | 1% | $100,000 |
Illustrative. Step-downs are common on bank loans and some agency programs.
Yield maintenance
The borrower pays an amount designed to give the lender the same yield it would have earned if the loan had run to term, typically calculated against a Treasury rate. When Treasury yields fall below the loan rate, yield maintenance gets expensive. When they rise, it shrinks, often to a stated minimum such as 1%.
Defeasance
Instead of paying the loan off, the borrower buys a portfolio of government securities that produces the same payments as the loan through maturity. Those securities replace the property as collateral, and the property is released. Defeasance is common on CMBS loans. It involves third-party costs and its total cost depends on rates at the time.
Lockout
A period during which the loan can't be prepaid at all, common at the start of CMBS loans.
Exit fees and minimum interest
Bridge loans are often more flexible but may carry an exit fee or a minimum interest period, where the lender collects a set number of months of interest even if the loan is repaid early.
Open period
Many loans have an open period near maturity, often the last few months, when they can be prepaid without penalty.
Common mistakes
- Choosing on rate alone. A sponsor planning a three-year hold may pay more in prepayment than they saved on rate.
- Not modeling the payoff. Run the cost at the most likely exit date.
- Missing a lockout. It can block a sale entirely.
In the package
Tell lenders the sponsor's likely hold period and exit plan. It helps them quote prepayment terms that fit, and it makes term sheets easier to compare.