In part 1 of our New Deal Checklist, we talked about how a mismatch between your loan term and how long you hold presents a hidden premium. For part 2, we are putting your prepayment penalties in a whole new light.
In case you missed our first blog (Term Mismatch And What It's Costing You), here is the context: a few months ago, we had a borrower ask a brilliant question. "Have we been making the correct financing decisions historically, or can we do better?" In other words, that borrower was out to understand how their decisions around financing affected their portfolio, and (as they would discover) how much they might have saved by making a different decision.
In response, we are out to empower those dedicated to constant improvement to take the same steps of evaluation. In the end? We'll arrive at a "New Deal Checklist" that will contain all the questions you should be asking yourself before acquiring a new loan, and maybe you can save millions too.
In part 1, we talked about the first piece of quantifying the "hidden" cost of your debt. In a nutshell, you are economically better off closing a 5 year loan than a 10 year loan, if your typical hold period is 2-3 years. We broke down how your spread and the yield curve play into this quantification, but there is another huge piece you should be quantifying.
Prepayment Penalties: Case Study
In the case of the borrower we mentioned in part 1, we compiled the prepayments for 33 of their loans, broken down by loan type. They were aware that Freddie fixed and CMBS frequently resulted in penalties, but they were surprised to find how much they'd been paying for Balance Sheet, LifeCo, and Value-Add.
Over a four year timespan, they paid over $19mm in prepayment penalties.
Prepayment Penalty as an Effective Interest Rate
Everyone considers their potential prepayment penalties before choosing a loan, but how many go back later and translate that into an interest expense?
Example: Let's say a $27mm loan closed on 10/1/2013 at an all-in interest rate of 4.95%. This 10 year loan was paid off 56 months prior to maturity (which means the borrower would have been better off choosing a 5 year loan).
Prepayment Penalty: For this loan, the prepayment penalty at sale was $1,898,500.
Effective Interest Rate Increase: Translating $1,898,500 into an interest rate, this prepay would have increased the rate by1.41%.
Overall: In this scenario, if the rate on paper at closing was 4.95%, quantifying in the prepayment penalty makes the interest rate effectively 6.36%in retrospect.
Would you choose the 4.95% quote if you knew the effective interest rate was north of 6%?
Pro tip - in the case study above, if the penalty had just one year less remaining, this borrower could have saved over $400,000. Maybe leadership is uncomfortable going from 10 years to 5 years, but perhaps 7 years would be a good compromise?