As rate hikes and inflation increase borrowing costs and wreak havoc on lenders’ ability to offer and close loans, the dynamics of market sentiment and pricing of the forward curves indicate that interest rates will decline in two to three years.
Increasingly, there is a greater imperative for real estate investors to act quickly to secure ever-elusive financing while maintaining the option to pre-pay loans when rates are more attractive.
The challenge: banks and CMBS impose hefty penalties and regulations to keep borrowers locked into lofty interest rates with little flexibility.
Read on to learn about the pitfalls of bank and CMBS pre-payments–and how bridge loan lenders like iBorrow offer the freedom and flexibility borrowers need.
The lowdown on lock-outs.
Since underwriting and re-underwriting commercial real estate loans is costly, most banks and CMBS structure five to ten-year perm loans with strict prepayment penalties to boost their earnings and offset liabilities, such as deposits, annuities, etc. The loss of a CRE loan reduces cash flow and can be hurt to a bank’s or CMBS’ balance sheet.
Banks and CMBS prevent pre-payment for an extended period of time, often known as a “lock-out” period. During the lockout period, which is typically one to two years, borrowers have no option to pre-pay or sell their property, even if a buyer approaches a borrower with a substantial offer.
You read that correctly: Lock-outs prevent borrowers from pre-paying or even selling their property according to the terms of the lending agreement.
Post-lock-out: punishing pre-payments.
When the lock-out period ends, the prepayment penalties begin.
Borrowers must pay on long-term loans at a rate that’s potentially much higher than that of a bridge loan from a private lender like iBorrow.
The prepayment penalties banks and CMBS use to protect themselves include:
- Yield maintenance – The most common prepayment penalty used by banks, yield maintenance compensates for the loss of interest that resulted from the prepayment of a loan. Yield maintenance is based on a predetermined formula and utilizes the forward rate based on the index the lender is using. Since the forward rate curve is currently steep–and it’s possible for interest rates to continue to climb–the cost to the borrower to prepay right now is substantial and poised to increase, especially on longer term loans.
- Defeasance – Defeasance is a method for CMBS lenders to maintain their yield when a borrower prepays a fixed-rate loan. Instead of paying cash to the lender, the defeasance option forces the borrower to exchange another cash-flowing asset (usually a U.S. government bond) for the original collateral on the loan. Defeasance is very costly as it requires financial engineering. Essentially, borrowers are replacing cash flow in a securitized product with various treasuries to mimic that cashflow to keep the bond buyers whole. Defeasance is always used by CMBS loans.
- Step-Down – This prepayment penalty uses a predetermined schedule of penalties–typically a percentage of the outstanding balance–for each year of the loan’s term. For example, on a 10 year fixed-rate loan, a bank might issue a 5% prepayment penalty in the first year after the lockout period ends, 4% in the second, 3% in the third, and so on. While more straightforward, costs of step-down pre-payments can be substantial to borrowers, especially in a rising rate environment.
How bridge lenders are different from banks and CMBS
Bridge loans are a bridge to the future.
Rather than lock borrowers up or issue massive prepayment penalties, bridge lenders like iBorrow structure prepayment penalties as minimum interest. This means if a loan is structured with 12 months of minimum interest, and the loan is repaid in month six, the lender is owed the interest they would have otherwise been paid in months seven through twelve.
These minimum interest payments are significantly lower than the rates a bank or CMBS charges, and given the Fed’s recent hike in rates, iBorrow is seeing many borrowers pursue bridge financing in lieu of traditional perm financing to capture pre-payment flexibility. Bridge loans are typically 12-48 months with extensions, naturally leading to truncated pre-payment periods.
In today’s market, bridge loans with nine months or less of prepayment penalties/lockouts are very competitive. Most lenders will require pre-payment protection for a majority of the loan term, leaving the last four to six months of the term open to prepay. iBorrow has no lockout period in its loan program
How borrowers benefit with iBorrow
iBorrow gives borrowers the flexibility to pay off loans at any time–with no lockout period. Period. iBorrow is able to offer this substantial flexibility for a number of reasons:
We Get It – We specialize in bridge lending and know that every deal’s timeline isn’t perfect, and delays in a sponsor’s business plan may prevent borrowers from exercising the pre-payment flexibility despite their initial intent.
Time to Ramp – It takes time to ramp up cash flow and display seasoning. If our borrowers are ready to seek out a new lender offering a lower rate, it will take time for the new lender to get comfortable and step in, which causes further delay.
Interest Accrual – Refinancing a property with a traditional lender takes 45-90 days, which gives the borrower another two to three months of interest payments, even if they are ready to pay iBorrow out in full.
It’s a tough market. Rising interest rates have not only left many lenders on the sidelines with the inability to close loans, it has also fostered an environment rife with harsh prepayment penalties as banks and CMBS look to optimize their balance sheets. In these times, borrowers need lenders who are partners.
The good news?
In addition to actively closing loans, iBorrow offers pre-payment flexibility to give buyers the options they need. iBorrow provides the ultimate lending triumvirate in this volatile market: short-term bridge financing with a sure close, flexibility on prepayments as the market continues to change, and creative structures to match loan needs.
Discover the real alternative in real estate lending. Learn more about why iBorrow remains the most competitive option on the market.