A.CRE

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.
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