As passive investors, it is important to know and familiarize yourself with the structure of the deal in which you are presented. One of the important areas to understand is within the financing terms. Financing, or leverage, creates additional risk for the investor and must be managed appropriately. One financial consideration is the terms associated with the prepayment of the loan.
Why should you be concerned about prepayment terms?
One of the fundamentals of syndication is the business plan. The operating plan is the guidebook by which the team of syndicators executes to improve operations and profitability of the asset, thereby allowing investors to achieve their returns. As part of the operating plan of many syndications, there is an intended hold period. That holding period can be 5 years, 7 years, or any number of years. During that hold period, the team is improving operations by executing to their business plan (renovating units, raising rents, adding units, renegotiating contracts, etc.). Sometime in the future, the team believes that they are positioned for a sale or refinance. In any case, they should have been aware of prepayment terms associated with their current financing. Some terms include what is referred to as Yield Maintenance.
What is Yield Maintenance?
According to Investopedia, Yield maintenance is a sort of prepayment penalty that allows investors to attain the same yield as if the borrower made all scheduled interest payments up until the maturity date. Why is this simple term of such critical importance? Well, it can impact the outcome of the deal if not properly understood or accounted for within the plan. After the improvements are made to the property and the team sells for the desired price, out of the proceeds they first closing costs and payoff the loan before profits are distributed to members and managers. With unexpected prepayment penalties in the form of yield maintenance, what was expected for returns and reality become two vastly different things.
How should investors mitigate the impacts of this requirement?
Experienced and astute investors do their due diligence, understand each of the important details of the loan and plan accordingly. In the case where the loan terms include yield maintenance, these considerations are simply planned costs associated with the resale. Naturally, the team would either modify the operating plan, tweak their financial structure for less leverage, plan a longer holdings period to sell at a price to cover yield maintenance and achieve the targeted returns, or find a better deal.
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