Don't Underestimate the Prepayment
With cap pricing up and the curve flat, many borrowers who traditionally opt for floating debt may be leaning towards fixed. One consideration often underestimated when entering into a fixed rate financing is the prepayment penalty.
Consider a 10 year deal at Treasurys + 2.20%. With the 10 year Treasury yield at 2.99% and a spread of 2.20% the all in rate would be 5.19%. Hypothetically, if you wanted to prepay the loan the next day, you’d be facing a penalty the size of the spread (2.20%), per annum, through Maturity. In other words, the penalty would be 2.20% * 10 * loan amount, or approximately a 22% prepayment penalty.
To have no penalty, 10 year rates would need to have spiked 2.20% overnight.
Rolling Down the Yield Curve
Obviously, nobody prepays on day 1 and rates are always moving. As time goes on, you have to account for rolling down the yield curve. At a minimum, a 10 year fixed rate deal typically has a 2 year lockout period over which the yield curve would be working against you.
The average 10 year Agency fixed financing is prepaid after 6 years, meaning the prepayment premium is driven by 4 year Treasury yields. The curve is flat today but assuming rates were unchanged 6 years from now, your penalty would be equal to 2.20% per year for 4 years, or 8.8%. That said, the current yield curve is an exception.
Since 2000, the spread between 10 and 4 year yields has averaged ~1.6%. In other words, in a normal rate environment you’d need to make up for the spread (2.20%) and rolling down the yield curve (1.60%), implying a penalty of 3.80% per year for 4 years, or 15.2%.
All this said, prepayments are just one consideration and that’s not to say fixed debt isn’t appropriate for your deal. We’ll never know your business plan as well as you do, but it’s important to consider the backloaded expense that can come in the form of a prepayment premium. For more considerations, check out our fixed vs. float analysis.
If you have any questions about the decision to float or fix on an upcoming financing, reach out to us at Pensfordteam@pensford.com or (704) 887-9880.