To Prepay or Not Prepay Your Loan? What Every Self-Storage Owner Must Consider Before Refinancing

July, 2015

Is the inevitable finally happening? Are interest rates starting to bounce from historic lows and begin their long-awaited climb upward? I don't have the answer, but what I do know is Treasury yields are up significantly over the past six months. On Jan. 26, the 10-Year Treasury closed at 1.68 percent. On June 10, it was at 2.41 percent, a climb of 73 basis points or 0.73 percent.

The good news is a 10-Year Treasury of 2.41 percent is still a low yield when compared to historic levels, and borrowers can still lock in long-term, fixed-rate mortgages in the mid 4-percent range. Does it then make sense for a self-storage owner to refinance his facility? That depends on your view of the interest-rate markets and the direction you think rates are headed. You must also consider the prepayment penalty on your existing loan and whether the economic consequences are too costly.

There are three major prepayment structures commonly used by lenders today: fixed-percentage or step-down, yield maintenance, and defeasance. Each has advantages and disadvantages. Here's what you need to know to make an informed decision about prepaying your self-storage loan.

Fixed-Percentage or Step-Down Prepayment

Fixed-percentage or step-down prepayment is the simplest structure. The lender states that a percentage of the unpaid principal balance is required as payment in the event that you pay off the loan prior to maturity. For example, the penalty could be 5 percent in year one, 4 percent in year two, 3 percent in year three, etc. This type of penalty often declines as the number of payments remaining decreases and is common with banks and many Small Business Administration lenders.

The benefit of this type of prepayment is you always know what the cost of the prepayment is regardless of interest-rate movement. However, as we'll see below, a fixed-percentage prepayment structure isn't beneficial if interest rates spike.

Yield Maintenance

Yield maintenance allows the lender or investor to maintain the same yield or return as they were generating from their loan. The lender usually looks to the Treasury market for the replacement rate and chooses the Treasury that most closely matches the maturity date of the original loan. The remaining loan payments are then discounted using the replacement rate as the discount factor. The present value of these payments is then compared to the unpaid principal balance of the loan, and the difference is the penalty-if the present value is greater than the outstanding loan amount. As interest rates rise and time passes, the resulting pre-payment penalty decreases and can become nil; the opposite happens if interest rates decrease.

However, lenders will often stipulate a minimum penalty of 1 percent. Yield maintenance is used with balance-sheet lenders making long-term, fixed-rate loans as well as insurance companies. It's also becoming more common to see commercial mortgage-backed securities lenders using this structure. The advantage is, in a rising-interest-rate environment, it's possible for the prepayment penalty to drop to 1 percent.

Defeasance

Defeasance is similar to yield maintenance in that the investor is looking to maintain the existing yield. However, with defeasance, the funds used to pay off the loan are employed to purchase a portfolio of Treasuries to emulate the cash-flow stream investors would have received had the loan not been prepaid.

Articles: July 2015

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