Overwhelmingly, commercial mortgages are granted to borrowers who tend not to be individuals, but rather tend to be commercial enterprises of some description.
In Canada, mortgages to individuals come with the right to prepay the loan, after 5 years, upon payment of an additional 3 month interest penalty “bonus”. This protection enabled consumers to negotiate longer term mortgages, without the risk of incurring excessive lender penalties.
This protection is not available to corporate borrowers, and since 2012 this also applies to Partnerships, who no longer have a mandatory prepayment privilege.
On the presumption that commercial mortgages are to commercial enterprises are typically “closed” for the duration of the term of the loan, what right or ability does a borrower have to prepay a loan? For the most part, no such privilege exists. Why? In simple terms, the lender, in granting the mortgage, is relying on the receipt of a predictable stream of cash flows over the duration of the loan term. This cash flow is providing a rate of interest, or spread, over that rate paid to the lender’s depositors, on a similar term savings product. In lender terminology, the oversight of these cash inflows and outflows is known as ALM, or Asset Liability Management. Any unforeseen disruption to a regular and predictable cash flow immediately impacts the lender’s interest income, most often to their detriment, as not surprisingly borrowers tend to repay higher rate loans, not below market rate debt!
Is there an alternative available to a commercial mortgage borrower in these circumstances? Yes, there typically is. Many lenders will negotiate a prepayment privilege in favour of a borrower. Prepayment will be determined differently from lender to lender, however the basic premise remains common. The lender will seek to maintain their anticipated yield, hence the common usage of the term Yield Maintenance Penalty.
What is the basis of the penalty determination? It is rooted in the logic that the lender wishes to earn an amount of interest which would have been earned had the request for borrower prepayment not been made. Some lenders may simply provide the borrower with language to the effect that prepayment will be accepted on a “yield maintenance” basis, while others may stipulate a formula, most often the sum of the present value of the anticipated remaining payments, and maturity balance, had the prepayment not been requested, discounted at a rate comparable to that rate which would be charged today for a mortgage investment of comparable quality, for the remaining term.
Herein lies the challenge for a borrower. A lender cannot be certain that a comparable quality investment is immediately available for them to put those prepaid mortgage funds back to work. The position of the lender may be to use a discount rate lower than current mortgage rates (resulting in a higher prepayment penalty), on the basis that although a comparable quality mortgage investment may not be readily available, the lender could most probably acquire a Government of Canada bond of like term, and will defer to using the bond yield as the discount rate. Knowing how your lender will treat a possible prepayment request is an important consideration in your initial mortgage negotiations.