I am in the process of purchasing a retail property. I negotiated for no prepayment penalty but that’s the terms in the prepayment clause ("Prepayment will be applied “in inverse order”). Of course this benefits the bank. How can I word this clause in a way that is fair- that any prepayment is applied to the principal and the interested in recalculated)? Anyone dealt with this problem?
Also this is a retail condo and has 5 units in it. I want to be able to sell one or two units. Would the lender be flexible regarding this given that Debt service ratio is satisfied?
You are buying multiple units, correct? You will have a blanket loan over the lot and you want the bank to release a unit if you choose to sell. The bank will want the debt reduced when you sell a unit before they release the unit.
Is the above correct? If so, what is the question?
Any debt reduction automatically reduces the amount of the interest that would be paid after that point. Are you looking to have the monthly payment amount reset?
Typical payoff terms for such a deal include a provision to establish a per unit payoff amount based on the original LTV.
For example, say the purchase price is $500,000 for the five units, and the total loan is $375,000 at a 75% LTV, which is $75,000 per unit. When a unit is sold your payoff could be the current balance divided by five, or the original per unit amount of $75,000. This is negotiable to a point. In recent years it has been a huge issue for condos because values declined as much as 75%, so banks are not willing to leave the payoff amount open-ended.
I can’t interpret the “inverse order” language without knowing how it is defined. Typical terms would be first applied to outstanding interest, then principal. This is usually not a problem. Just make sure the note describes the method under which the interest is calculated, preferably a fixed rate based on the outstanding balance. Some banks mask a shorter amortization term by changing the way interest is calculated against an index (such as LIBOR).
From a limited reading I did, if the payment is applied in inverse order, the bank will apply the prepayment from the very last of the payment first - which is mostly principal. And you still pay the same interest amount (i.e. interest over the original loan amount). Therefore, if the prepayment is applied in inverse order, your interest amount still stay the same (and not recalculated) but the length of the payment gets shorter.
According to my lawyer, the prepayment being applied ‘in inverse order’ is the norm these days. But he wasn’t sure how this was really calculated.
[QUOTE=ray@lcorn;886191]Typical payoff terms for such a deal include a provision to establish a per unit payoff amount based on the original LTV.
In recent years it has been a huge issue for condos because values declined as much as 75%, so banks are not willing to leave the payoff amount open-ended.
ray[/QUOTE]
Ray, as it stands, the provision regarding payoff amount is open-ended. Shall I leave it as is or should I push to define a payoff amount? My LTV is very low.
Thanks for the detail. The inverse order as defined is another variation of an accelerated payment/amortization schedule I was referring to above. I disagree with the attorney… for some banks it is the norm, but others not so much.
I’ve successfully negotiated the clause away by using competitive quotes from other banks. That may or may not be an option here. The problem is this: the immediate effect of the sale of one or more units (any number less than all) will put the project below minimum debt service coverage ratio that is required in the underwriting for a commercial loan. I would not agree to the pre-payment methodology unless there is also a recalibration of the DCR or a release of the DCR as a grounds of default.
Another way to approach it is to use a credit line structure rather than permanent (or mini-perm) loan. I suspect the bank plans to hold the loan in their portfolio, so there is a lot of latitude as to how they structure the deal.
In re the release: At minimum I would request a pre-determined release schedule, perhaps based on 20% of the principal balance per unit rather than dollar amount. That covers both parties as far as having a pre-set formula, but leaves you with the risk of market-value falling below the loan amount. You get the off-setting advantage of a declining payoff which should be considered a risk premia for taking the market risk. (I assume you have done adequate due diligence on market supply and demand and that you feel comfortable with it or you wouldn’t be doing the deal in the first place.)