Jim Lemos
The lack of sale transactions continues to stifle the commercial real estate market and a recovery nationwide. Much attention has been focused on the “market value” gap between buyer and seller over what is market value today. However, while the value gap has started to close, another issue has raised its ugly head. Investment sales brokers cite the severe impact a lender’s prepayment penalty is having on potential sales transactions.
The current U.S. Treasury rates now stand at levels unseen since the 1950s. No one in the commercial real estate business today was in business making loans at that time. Back then lenders were not dealing with yield maintenance calculations or the more obtuse and expensive defeasance penalties prevalent today. The fact that a borrower needs to hire a group of consultants and attorneys to handle a CMBS defeasance payoff suggests the concept might have been invented by our Congress. Needless to say the costs associated with prepayment of a loan today is prohibitive in far too many cases. The result is obvious; a sale trying to absorb a 15 to 25 percent prepayment penalty is a transaction that is stillborn.
Mortgage bankers are reacting to investment sale professionals complaining there is no sales “traction” in part due to the immense size of the prepayment penalty. It is not unusual today to see the prepayment penalty for a loan with 3 to 5 years from maturity calculated to exceed 20 percent of the loan balance. Furthermore, as summer ends and the months tick by, the short end of the Treasury curve is falling off a cliff with 2-year rates now at 0.45 percent. Unfortunately brokers or property owners hoping the passing of time will reduce the penalty now face a penalty that just keeps rising as Treasury rates fall to near zero. If the “double dip” or deflation forecasters are correct, it is possible we could be looking at even lower rates into 2011.
The end result is a market partially “frozen” by the position taken by most lenders today, stating they are unwilling or unable due to policy rules, insurance regulations or bondholder covenants to negotiate a reduced prepayment. Portfolio management is an important tool, and considering the present and future Treasury yield curve, this “head in the sand” attitude may prove to be a mistake and is causing harm to the commercial real estate market. Not unlike the criticism aimed at banks for not lending in this environment, lenders inflexibility on what are near onerous prepayment penalties is worthy of scrutiny and concern.
Lenders in select cases have been willing to negotiate a reduced penalty often if the lender deems there to be risk in that mortgage transaction or possibly if they have too much exposure in a market or product type. During 2009, some lenders offered reduced fixed payoff penalties, overlooking contract yield maintenance or defeasance to incentivize payoffs and reduce their mortgage loan portfolio. This often resulted in the best deals being ones that paid off as sales or refinanced transactions were consummated.
Regardless of the lender group or what the loan documents say, it is time to look in the mirror and realize these lenders are contributing to the malaise that is now stretching towards year 3. Just ask the Japanese how its feels in year 14. The status quo kills too many transactions and the normal flow of the market has been impeded. Alternately by selecting to negotiate a fair, fixed prepayment penalty, lenders can assist a sale or refinance and still manage to receive excellent yields in their mortgage portfolio. Due consideration should be given to reasonable, fair pricing when reviewing a prepayment request given the market conditions.
Finally, if some economic pundits are right and we are in a period of long-term, low interest rates, by accepting a reduced fixed penalty today it is potentially a better economic return than waiting to see 6 to 8 percent mortgage loans maturing in a sub 5 percent (or even 4 percent) rate environment from 2011 to 2013. Broader consideration and a move to less strict prepayment policies should be implemented to assist current market conditions and restore some normalcy and flow into the commercial real estate market that will benefit all market participants.
— Jim Lemos is a Principal/Mortgage Banker with Texas Realty Capital, LP in Austin, Texas.