Why You Should Say Yes to Paying a Defeasance Fee

With interest rates increasing, some investors are taking a moment to review their loan portfolio to see where they can mitigate the potential impact of higher rates. G.H. Palmer has been fervently combing through his portfolio for nearly a year—and he has seen big benefits in refinancing early and paying a pre-payment penalty to get into a more profitable loan structure. Gary Tenzer, co-founding principal at George Smith Partners, has been guiding the process. The most recent refinance under this model is the $158.8 million in financing for Colony Townhomes, a 752-unit multifamily property located in the Canyon Country community of Santa Clarita, which GlobeSt.com has learned of exclusively. The new loan replaces a HUD loan, also arranged by Tenzer. It is interest-only and non-recourse at a fixed rate of 4.29% for a 10-year term, and has a 65% loan to value.

While Tenzer has worked with Palmer to secure several of these loans, this one was a little different. “On this deal, we were taking out a HUD loan, so the economics are a different. The other loans had only two or three years left until maturity,” Tenzer tells GlobeSt.com. “This loan had 23 years left until maturity. The way that the pre-payment penalty works with HUD is that there is a step-down prepayment. We were within a period of time where it made economic sense to pay it off at the prepayment penalty relative to the benefits.”

While the original loan was secured only seven years ago, the increase in property value and cash flow on the property made it possible to use this method to secure a new loan despite the pre-payment penalty. “The most important thing is that the value of the property has gone up quite a bit and the cash flow has gone up quite a bit,” says Tenzer. “That is the most important driver here. The interest rate went up a little bit, so the debt service went up by doing this; however, there was a substantial cash-out.”

Rising interest rates were the chief impetus in evaluating the loan, according to Tenzer. “Palmer believes that interest rates are going up, and he is taking advantage of borrowing at lower rates while he can and harvesting equity at those rates while he can at lower rates,” he explains. “Plus, he is still doing development, and he can reinvest that equity into future projects.”

While G.H. Palmer has been the biggest sponsor of this model, Tenzer is encouraging other investors to look at this option, too. With interest rates increasing, however, the opportunity to take is closing. “There are opportunities, but those windows are closing,” he says. “As rates go up, it makes sense to do this to get ahead of further interest rate increases, and the trade off with defeasance gets better.”

Of course, this isn’t an option for everyone, but investors with long-term debt should consider it. Tenzer has developed an algorithm to quickly determine who could benefit. “It all depends on the pre-payment penalty, the current rate and the amount you can borrow,” explains Tenzer. “It is a financial calculation, and I have developed a model to do the calculation to come up with an answer pretty quickly as to whether it makes sense or not.”

Even for investors that could benefit from this option, it can be difficult to accept paying a sizable pre-payment penalty, even when there are substantial gains over the long-term—but that could mean missing out on a good opportunity. “Real estate is a long-term investment, and you have to look at it over time,” says Tenzer. “You can’t look at it as a snapshot.”