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The Importance of Correct Debt Selection

An interesting piece of information was brought to our attention when we recently toured a potential deal. The seller had over $4.4M in a prepayment penalty for the remaining years of their 10-year fixed note. The reason for the large prepayment fee is yield maintenance. Yield maintenance means the borrower pays the lender for any interest owed (less what the lender can re-lend the money for) for the duration of the loan.

For example, if an apartment was purchased 3 years ago at 5.5% interest fixed for 10 years and today’s rate is 3.5% interest fixed for 10 years then the borrower would owe 2% interest to the lender for the remaining 7 years.

We did not make an offer on the property. I believe the seller will have difficulty finding a buyer because of their current debt situation.

Having the right financing per project is extremely important. The apartment lending industry is very competitive right now with low fixed rate longer-term debt (called fixed) and low variable rate shorter-term debt (called bridge.) To avoid “debt calamities,” when we evaluate an investment property, we make sure we use the best financing option. In the table below, I have laid out how our group views both financing options.