Pre-payment penalty TRAP DSCR loans

[Kenny Simpson]

Many new and experienced real estate investors will FALL into the pre-payment penalty TRAP and it might really bite them in the A$$ or cost them on future deals.  Going through the last 2008 real estate crash many people went with longer term loans (commercial loans) with pre-payment penalties that were yield maintenance instead of step down pre-pays.  Many of the banks that would do multifamily loans STOPPED lending so many people flocked to Agency debt ( Fannie and Freddie 5 + unit loans).  At the time is seemed like the best thing to do but when the market, banks and financing opened up years later and the real estate market started to recover these borrowers quickly realized the pre-pay they locked into, literally TRAPPED them from selling, cash out refi or just lowering the rate.  This caused stress, headache, lost opportunity to pull cash out and buy another property, lower rate and save $$.

Now here comes 2022, I am seeing a very similar pattern that is starting to arise in the commercial loan market,  BUT what has me really concerned for borrower that locked into a DSCR loans that many borrowers locked into @ 7,8,9% rates with a 5%, 5 Year pre-pay or even a 5,4,3,2,1. I wonder if they really understand what they locked into, did they think long term, do they really know the cost of the pre-pay? What if they have to sell? What if there property is negative cash flow and they do NOT have the opportunity to refinance to lower rate/payment? Lots of borrowers did these DSCR loans on STR, investment properties and etc. Will they feel or experience the TRAP.  Could this cost them opportunity or could they even lose the property?

If you are considering a DSCR loan, DONT just look at the rate, look at the whole picture? Think short term and long term. Taking a higher rate, lower pre-pay could make the most sense and flexibility in the future is the way to go.

Everyone that I knew that locked up Agency debt after the 2008 crash and did NOT remain flexible regretted it 100% and it really hurt their growth and kept them out of the real estate game for a long time.  

Thoughts?

[Nick Belsky]

@Kenny Simpson

I don't agree that prepayment penalties are a trap... that sounds more like a poor broker/loan officer who didn't due their client a service and ensure that the terms of the prepayment penalty was thoroughly discussed and understood.  I get a lot of reports that this is all too common.  Clients feel lied to or deceived when they find out they either didn't know or didn't understand what PPP is and how they work.

Prior to March 2022, PPP was a non-issue for most of clients as they'd lock into low fixed rates for 30 year terms and planned on holding long term, so no biggie.  In today's market, PPP is a huge deal and should be talked about with clients far more than rate.  Rates change, PPP terms don't.  The weight of a PPP comes down to the investor and how they plan to hold or sell the property and over what time frame.  Rates are inconsequential right now to many seasoned investors.  Refinancing or paying a little extra on your payment can easily offset nearly any rate.  PPP, on the other hand can cause issues to your exit, especially if the investor has short term plans for the property.

Personally, I haven't sold a loan with a hard 5% penalty with a 5 year term.  For long term holders, the 5yr Step-Down has been fine.  If investors want more flexibility in an uncertain market, the 3yr Step-Down is very popular right now as well.  For those who want complete freedom, a 1yr PPP or a bridge with no PPP are a winner.  The 3-2-1 is best for most in this market, IMO.  The 1% in year 3 is negligible to most scenarios and is written in as a cost to cover when sold or refinanced.  Really, its more of a 2yr period that has more significant impact.  The loan amount also plays a big role.  The %s on a $250,000 loan versus a $1.5MM loan are not in the same realm of impact...

I agree with @Stephanie P. as well.  If you are in a negative cash flow situation and want to blame rates, then you need to trim fat, and/or bring more bread.  If you can't, then walk away from the table.  Many are seeking short term Interest Only options right now to improve cash flows.  Way too many are quick to blame rates for not making a deal work, when in reality, if rate is truly the make or break variable, then you are already losing.

Several of my clients invest in STR in the Smokys and are booked out solid for the next 18 months. I see some STR markets struggling, but many are still thriving. The market you invest in comes down to due diligence and choosing the right markets. The Smokys have some entry barriers for sure, but overcoming those barriers can yield very high reward. You almost can't go wrong near a national park or on a beach... just saying.

Cheers!