by Brian Holstein, US Hotel Advisors
Are you, like most of the hotel world, evaluating an exciting amount of potential acquisitions, new developments and property renovations? Are you nervous about the $350 billion of CMBS loan maturities looming over the next three years? You're probably in awe of how low interest rates have remained and how loose the loan markets have been, especially given where we came from a few years ago. Perhaps you are eager to capture trapped equity behind a mortgage you put in place on a steal of an acquisition during the downturn.
Whatever makes you excited…or anxious about the next few years, you've been around the block enough times to know that such a cooperative economy and capital market won't last forever. It's time to ask yourself, "Does it makes sense to bite the bullet and pay the penalty to refinance early?" The answer may surprise you!
Not all Prepayment Penalties are Created Equal
Prepayment penalties come in the form of static points, declining points, yield maintenance and defeasance. If you are lucky enough to have a penalty in the form of static or declining points, it probably means you are unlucky enough to have a recourse loan. Most non-recourse loans come with yield maintenance or defeasance. Both yield maintenance and defeasance penalties are generally the same amount as they are both merely a discounting of future interest payments at the risk free rate.
Estimating Prepayment Penalties
Presented below are three typical prepayment scenarios. Each scenario assumes an original $10 million, 10-year loan, with 25-year amortization. The interest rates vary based on the average interest rate of CMBS hotel loans originated in 2005, 2006 and 2007.
Each scenario assumes prepayment in January 2015. The table below should give you a good indication of the approximate prepayment penalty for loans originated between 2005 and 2007.
Analyzing the Data
A prepayment penalty of $280,000+ for a loan maturing in 11 months is cheaper than a penalty of just over $1 million for a loan that matures a few years out. Without giving it more thought, you may decide that prepaying with only one year until maturity makes sense, but prepaying with three years remaining is prohibitively expensive. Fortunately, the answer is not so simple, and depending on your view of where interest rates are heading, both scenarios may call for an early refinance.
One of the most common reasons that a borrower decides to refinance early is the perception that rates are at an all-time low, and probably won't be for much longer. The reality is that the 10-year Treasury rate is currently at an all-time low, both on a five and 10-year average, and only 83 basis points above the all-time low spot rate reached in July 2012.
Prior to the Great Recession, it was not uncommon for lenders to write forward commitments on loans that were not ready to be closed. Such lenders would charge an upfront fee, an on-going fee, or a combination of the two, to lock rate far ahead of closing. Usually the period of time was limited to 12 months, but in certain cases, and for certain borrowers, that was extended beyond 12 months. Unfortunately, the days of the forward loan commitment are behind us. This is due to a combination of erratic capital markets and interest rates (which make it nearly impossible to properly hedge), and additional bank regulation.
Fortunately, there is an alternative to the forward commitment — the "Hedge Theory." The theory is simple. Rather than pay a new lender to lock your interest rate over an extended period of time prior to closing, pay your current lender to retire your existing loan early, close today, and amortize that prepayment penalty over the amount and term of your new loan. I will use the same three payoff scenarios to further elaborate the Hedge Theory below. Each new loan scenario assumes $200,000 of closing costs, a varying prepayment penalty and $1 million of cash out for new projects.
As shown above, with approximately one year remaining until maturity, the "Net Defeasance Cost" (Defeasance Cost less interest savings through existing loan maturity) equates to approximately 27 basis points of additional annual "cost" on the new loan.
In other words, if you were to prepay 11 months early at a cost of $251,482, and rates moved more than 27 basis points over the following 11 months, the money spent to lock in lower rates today (Net Defeasance Cost) would be considered money good and your hedge would look like a wise idea. If rates moved less than 27 basis points over the same 11 month period, the hedge would look more expensive but certainly not a waste of money. If rates were to actually drop over that 11-month period, then you made the wrong decision as you could have avoided the prepayment penalty all-together and still received a lower rate.
The same analysis can be applied to the 23-month and 35-month scenario. If you think rates will move more than 62 basis points over the next two years, and 91 basis points over the next three years, then you should prepay your loan now and take advantage of today's low rates. Based on the latest Wall Street Journal interest rate survey of 50 economists, such interest rate movements seem likely. The WSJ survey, shown above, predicts a 115 basis point movement over the next year and a 157 basis point movement over the next two years. Such rate movements would be a lot more expensive than your prepayment penalty. The survey does not go out more than two years, but one would assume that rates would continue to climb, barring a significant recession.
Cost of Capital Theory
This theory is based on the basic premise that debt is cheaper than equity. Rather than focus on interest rate hedging, the Cost of Capital Theory focusses on the cheapest way to raise capital for acquisitions, new development or property renovations (elective or brand-mandated).
As shown above, not all of the additional capital borrowed is "useable" funds. The only portion that is useable is the $1 million of "cash out". Therefore, we take the initial annual interest associated with the total additional capital borrowed and divide into only the useable portion of funds. The result is a cost of capital that ranges from 6.3% to 9.5%, much lower than the typical cost of equity.
When taken out of context, the size of a prepayment penalty may deter you from entertaining an early refinance. As you dig in a little deeper, most borrowers realize that if you are able to finance the cost of your prepayment penalty within your new loan, unless you think low rates are here to stay or your cost of equity is in the single digits, it almost always makes mathematic sense to refinance early.