Fixed-rate Loan with Yield Maintenance
There are many benefits to obtaining long-term financing on your multifamily projects from Fannie Mae or Freddie Mac. These government-sponsored enterprises (GSEs) agencies, Fannie Mae and Freddie Mac, provide federally backed mortgage guarantees, so the buyers of these bonds require minimal risk premiums. Therefore, these Agency Loans offer some of the most attractive loan terms available to multifamily properties, including fixed-rate loans that eliminate the risk of interest rate fluctuations. These loans have durations of 5 years or more, require stabilized occupancy and income, and range from $5 million to $100 million. The Debt Service Coverage Ratio (DSCR) is typically 1.25 to 1.4, and the loan-to-value (LTV) range is 65% to 80%.
Origination and servicing of these loans for the agencies are made available through licensed lenders called Delegated Underwriting and Servicing (DUS) lenders. Examples of these include Berkadia, KeyBank, and Greystone. The GSEs set loan programs, but the underwriting methodology can differ between agency lenders, producing very different quotes. The underwriting differences can deliver varying loan proceeds even though Interest Rate, DSCR, and LTV may be equal between agency lenders.
One of these agency loans' most attractive loan terms is the non-recourse feature, meaning the borrower is not personally guaranteeing repayment of the loan. This certainly gives a property owner reason to sleep easier at night, but there are associated costs. With a fixed rate over longer durations, the rate is usually higher than a floating rate over the same period. Through this, the DSCR, and the LTV, the lender is compensated for this additional non-recourse risk. The Pensford analysis of float vs. Fixed-rate concludes that over time, the floating rate costs the borrower less because the market frequently overestimates the future Fed Funds rate. Also, remember that the higher interest rate raises the debt burden calculation of DSCR. Loan assumption is an often-allowed loan condition, adding to marketability in the right economic conditions, such as a higher Fed Fund rate & tighter lending environment.
A significant negative for these agency loans includes prepayment penalties such as Yield Maintenance. This loan covenant provides 100% call protection to the lender, where there is protection against market interest rate changes. The calculation for this fee considers the remaining term of the loan, past interest earned, and the loan rate compared to the current market interest rate. For example, let’s look at the 2022 interest rate market, where a dramatic increase occurred throughout the year. A loan interest rate from 2020 is significantly lower than 2022 new loan rates (earnings to Lender). In that case, the yield maintenance will be lower because, essentially, the Lender can reinvest the money paid back at higher rates in the current lending market. On the contrary to this example, executing a higher fixed-rate loan in 2022 with yield maintenance is undesirable, with expectations of lower market rates within 24 months. This lender protection allows for superior loan terms to be offered to the borrower, but it can be expensive to terminate early.
Disposition of the property can be significantly inhibited by this expensive yield maintenance clause, limiting the exit strategy available to the owner. Unless the past loan duration is five or more years and the current interest rate market is significantly higher than the loan rate, opportunistic selling of the property in the near term is usually cost-prohibitive. This added expense makes these loans generally suitable for business plans with long-term holding periods. Even the assumable loan clause can demand a higher selling cap rate because it is less versatile for a Buyer, lacks an interest-only period available with new loans, has lower leverage because of past principal reductions, and may have unattractive interest rates. There are positive attributes to these fixed-rate loans, but these negatives need to be extensively analyzed to determine whether they fit the investment group’s goals.
We will always underwrite deals conservatively at Colonial Company and Colonial Commercial Realty. Therefore, it is essential for yield maintenance and loan assumption costs to be included in future disposition calculations. Depending on the negotiated details, these increase the cost incurred by either party, and the cap rate is frequently adjusted upward to account for this, thereby lowering the sales price. And because of the current elevated interest rates today, it is reasonable to underwrite deals with some expectation that a refinance within the near term is likely. It is important to stress test various refi rates and start dates, keeping the assumptions credible, objective, and not overly optimistic. Other considerations should be financing with a step-down prepayment penalty, a shorter loan term, and finding bank debt offering similar terms.