While geopolitical strife and economic volatility can make even optimists frown, every challenge also comes with an opportunity. For commercial real estate investors, rising interest rates may seem on the surface to be nothing but negative. However, there are some circumstances in which higher rates could prove advantageous to property owners – specifically those with mortgages subject to yield maintenance as their prepayment premium structure.
When Treasury rates are on the rise, there’s an immediate direct effect that reduces prepayment premiums. Yes, if rates are higher today than they were yesterday, the yield maintenance premium is lower today than it was yesterday. Many borrowers assume that higher interest rates mean refinancing is not a viable option, but if they have a loan with a prepayment premium, the math could work in their favor to refinance now.
Prepayment premiums on CRE loans
Prepayment premiums, which are relatively common on commercial real estate loans, protect lenders and mortgage investors from an early loan payoff. If a borrower pays off the loan early because of a property sale or a refinance, the yield maintenance premium would be calculated as follows: Yield maintenance = present value of remaining payments on the mortgage x (interest rate – Treasury yield).
Borrowers exploring Fannie Mae or Freddie Mac loans often opt for a yield maintenance prepayment premium to gain the most favorable loan terms available, such as a lower fixed interest rate for the life of the loan, flexibility for several years of interest only payments and potentially even lower closing costs. The borrowers take the calculated risk that they won’t need to pay off their loan early.
Two options to access equity: Refinance or Sell
Historically, borrowers with a prepayment premium block out any thought of refinancing during the premium period. But for the first time in a very long time, it’s worth exploring – especially to access equity in the asset.
For example, if a property was acquired in 2017 for $13 million with a 10-year, $10 million loan, the property value, five years later, has likely increased by 50%+ over the last three or four years, which means significant built-in equity. Today, because of rising Treasury yields, a prepayment premium could be a fraction of what it was as recently as 12 to 18 months ago. To capture some of that equity and pay off the loan a year ago, the premium would have likely been $4 million. Today, because of the rising interest rate environment, that premium may be just $1 million or less. Additionally, there could be a tax benefit in writing off the expense of the prepayment premium.
Agency debt (Fannie Mae and Freddie Mac) continues to be very attractive and can close quickly. However, for those looking to maximize cash-out, a HUD loan may be worth exploring, as HUD loans offer 80% LTV without limitations on the market. This loan type typically takes longer from engagement to closing, but can offer longer loan terms, up to 35 years.
Some property owners may be considering selling to access their equity. Typically, sophisticated sellers use a 1031 exchange to mitigate capital gains taxes. However, in the current economic environment and with the time constraints associated with a 1031 exchange, rushing to invest into a new project could lead to investing equity at less favorable financial terms and risking a potential short-term decline in the property’s value. While not every property owner can benefit from a cash-out refinance in today’s environment, it’s worth consulting your CRE advisors and lender to run the calculations for a comparison. The results may be surprising.