Lock Out

A common clause in a CRE loan agreement. This is the period of time after disbursement that a borrower is not allowed to prepay the loan. Lenders will many times enforce a lock out period along with prepayment penalties after the lock out period as a way to ensure they are receiving earnings off the money they are responsible for disbursing.

Putting “Lock Out” in Context

Case Study: James River Apartments

Old Dominion Realty Partners, a real estate private equity firm, acquired James River Apartments, a 200-unit market-rate multifamily community in Richmond, Virginia, for $30 million. To finance the acquisition, the firm secured a $21 million loan from a regional lender at a 4.5% fixed interest rate with a 30-year amortization schedule. The loan agreement included a five-year lock-out period, during which the borrower could not prepay the loan without significant penalties.

How Lock Out Applies in This Context

The lock-out clause ensured that the lender would receive consistent interest income for a minimum period, protecting its anticipated return on the capital disbursed. For Old Dominion Realty Partners, this clause limited their ability to refinance or pay off the loan early, even if interest rates declined or the property appreciated significantly during the lock-out period.

Key Considerations

• Operational Flexibility: The five-year lock-out period required Old Dominion Realty Partners to carefully assess their long-term investment strategy before agreeing to the loan terms. This was especially critical as refinancing during the lock-out period was not an option, even if market conditions became favorable.
• Prepayment Risk Mitigation: By including the lock-out clause, the lender reduced the risk of early prepayment, ensuring it would recover origination costs and achieve a predictable return on the loan.
• Potential Costs After Lock Out: Once the lock-out period ended, the loan agreement included a step-down prepayment penalty. For example, a penalty of 3% of the remaining loan balance would apply in year 6, decreasing to 2% in year 7, and 1% in year 8.

Implications for Borrower Strategy

The lock-out period aligned with Old Dominion Realty Partners’ planned hold period for James River Apartments, which was projected at 7–10 years. By selecting a loan with terms that matched their investment horizon, the firm minimized the impact of the lock-out clause on their ability to execute their business plan.

However, if the firm’s strategy had shifted—for instance, deciding to sell the property in year 3—they would have faced significant limitations due to the inability to prepay the loan. This underscores the importance of aligning loan terms with the investment’s projected timeline and flexibility needs.

Conclusion

This hypothetical scenario illustrates how lock-out clauses in commercial real estate loans are used to protect lenders while potentially limiting borrower flexibility. By understanding the implications of a lock-out period and incorporating it into their strategic planning, borrowers can make informed decisions that balance financial objectives with operational constraints.