Curtailment

A type of prepayment which reduces a mortgage loan’s outstanding principle balance. Curtailment can be done by either increasing one’s monthly payments or repaying a lump sum amount, both of which would shorten the loan maturity period.

Putting ‘Curtailment’ in Context

Scenario Overview:

Summit Equity Partners, a real estate private equity firm, has recently acquired Highland View Apartments, a 120-unit market-rate multifamily property in Cheyenne, Wyoming. The acquisition is part of their core-plus strategy, targeting stable assets in growing secondary markets with potential for moderate operational improvements.

Property and Financing Details:

Highland View Apartments was purchased for $18 million, with Summit Equity Partners securing a $13.5 million mortgage at a fixed interest rate of 4.25% with a 10-year term and a 30-year amortization schedule. The property generates a net operating income (NOI) of approximately $1.3 million annually, and the initial debt service coverage ratio (DSCR) is a comfortable 1.8x.

Curtailment Decision:

Two years into the investment, Summit Equity Partners has successfully increased occupancy and slightly raised rents, which resulted in a higher-than-expected cash flow. The firm’s asset management team decides to apply a $250,000 curtailment to the mortgage, aiming to reduce the outstanding principal balance and improve the property’s long-term financial performance.

Impact of Curtailment:

The $250,000 lump sum curtailment immediately reduces the principal balance from approximately $12.8 million to $12.55 million. This curtailment will not only reduce the interest expense over the remaining loan term but also shortens the loan’s maturity period, assuming the monthly payments remain unchanged.

Financial Analysis Post-Curtailment:

Prior to the curtailment, the monthly mortgage payment was $66,645. After the curtailment, while the payment amount remains the same, a larger portion of each payment will now go towards principal reduction rather than interest. This action accelerates the loan amortization, effectively shortening the loan’s duration and saving the partnership significant interest expense over the life of the loan.

Conclusion:

In this hypothetical scenario, Summit Equity Partners’ decision to apply a curtailment demonstrates a prudent strategy to optimize the long-term financial performance of Highland View Apartments. By reducing the outstanding principal balance, the firm not only enhances the property’s value but also positions itself to potentially refinance under more favorable terms or even exit the investment earlier than initially planned.