Solving the Prepayment Puzzle

Kathy Kahng, president of the co-op board at 159 Madison Avenue, has plenty of sophisticated financial minds advising her. Her treasurer is the comptroller for one of the country’s biggest department store chains, and another member is an executive at a top European investment bank.

So her board was hardly unaware of how much interest rates had fallen recently and that the co-op might save by refinancing its underlying mortgage. To that end, she assembled a subcommittee to look into the possibility, and then retained David Lipson, a seasoned and respected mortgage broker, to advise and assist.

In the end, she says, the board calculated that by refinancing two years before the old mortgage ran out, it could save more than $30,000 per year in costs for the underlying loan on their 118-unit building. That was even with prepayment penalties. Perhaps equally importantly, by completing the deal in late winter of this year, the co-op avoided the risk of a sudden rise in interest rates in the next two years.

In addition, the property got an attached line of credit that it hadn’t had before. Kahng says that, all in all, it was a “pretty pain-free experience.” Even so, the whole process – fully investigating the issues, getting the best possible terms, and then completing the deal and the associated paperwork – took the co-op almost a year.

What’s more, her positive experience may not be a universal one.

Beat It

The problems start with that matter of prepayment penalties. After all, although federal law requires that all individual homeowners – including buyers of co-ops and condos – have the right to prepay their mortgages at any time without penalty, few if any co-ops in the New York area possess that power with regard to their building’s underlying mortgage.

In fact, you have to go back to the days when Michael Jackson’s Thriller was topping the Billboard album charts (for non-pop fans, that’s 1983) to find a time when New York City co-op associations could obtain mortgages that did not demand significant penalties for early prepayment.

Veteran attorney Arthur Weinstein, who represents dozens of co-op associations and has dealt with scores of refinancings, wistfully acknowledges that he’s been in the business of handling negotiations for boards long enough that he remembers the days when mortgages without prepayment penalties could be had.

But, as he observes, “I’m one of the few to have been around that long.” And even in those days, such loans “were a distinct minority.”

Moreover, the recent trend has been toward the lender asking boards to agree to mortgages requiring that co-op associations seeking early prepayment pay prepayment fees equal to the greater of 1 percent or a “yield maintenance” amount. This is generally defined as a prepayment premium that allows investors to attain the same yield as if the borrower had made all the scheduled mortgage payments.

The result is that just as interest rates approach historic lows not seen since the early 1960s, co-op boards find themselves stuck with older mortgage loans that require them to pay sometimes quite enormous penalties to refinance.

Many Causes, Few Remedies

Weinstein and other players in the field say there are many causes for this right now but only so many remedies.

One reason for the shift may be a gradual change in the nature of the lending and the players providing it. Stuart Brock, director of mortgage brokerage for Time Equities, notes: “If you look back 20 and 30 years, more of the local co-op lending came from savings and loans, which were offering term loans from their own balance sheet.”

By contrast, today’s biggest local lenders, like National Cooperative Bank (NCB), are often securitizing the loans, combining and then breaking them up into financial instruments sold to separate parties. Since it would be inordinately difficult and complex to repay all those parts from different tranches owed to different bond buyers, the loan originators generally want to make prepayment difficult and costly.

This trend of turning co-op building loans into packaged instruments has not been stopped by the collapse of the bulk of the collateralized debt obligation market during the financial panic of 2008. After all, co-op building mortgages are usually Triple-A rated and failure is rare. Necessarily, the securities markets still see them as solid investments.

Hence, while area banks like Valley National Bank and New York Community Bank continue to offer loans directly from their own portfolios, these tend to be not as competitive as Fannie Mae and Freddie Mac direct lenders or CMBS products.

Savings and loan banks can be competitive, with five- and seven-year co-op underlying mortgages. Standard, though, is the 10-year loan, says mortgage broker Lipson, who is also director of Century Management’s mortgage division, which specializes in underlying mortgages for co-ops.

Thus, while co-op associations cannot prepay their loans as easily as individual borrowers can, they also need not wait 25 or 30 years to pay off their mortgages. (Lipson notes, however, that there are still a few 25-year “self-liquidating” mortgages in the New York City marketplace that were issued long ago by JPMorgan Chase and others.)

Benefits of a Short Life

This short loan lifespan of co-op loans is beneficial in a number of ways. For one thing, a 10-year loan can match the life cycle of many buildings’ systems.

“Your roof usually lasts 15 to 25 years. An elevator might need to be replaced at 20 to 25 years, your heating system at 15 to 25 years. And Local Law 1198 requires that the envelope of a building of six stories or more has to be checked every five years. That means hiring a licensed engineer or architect, confirming they’re in safe condition. Then there’s sidewalk replacement, window replacement, repairing the lobby,” Lipson says. “Obviously, all these can be expensive. But, with each 10-year mortgage, you can plan out the costs and what to expect.”

It is rare, of course, for a co-op to ever go without a mortgage. Instead, most move from one loan to another at the end of each borrowing cycle. For many buildings, the mortgage supplies a pool of capital ready and waiting for ongoing needs.

“Most co-ops use refinancing to pay for capital improvements,” Tudor Realty Director David Goodman explains.

The financing provided by the new mortgage should then be supplemented with a line of credit taken out at the same time as the mortgage, along with insurance. Since lines of credit usually come with floating interest rates, in many cases these have dropped.

“Many underlying mortgages offered to co-ops won’t permit a secondary or ‘junior’ secured mortgage, or an unsecured line of credit. So, if something comes up, and you need more money suddenly, the co-op could really be stuck without the availability of such additional loans,” Weinstein, the attorney, says.

Kahng, the board president, says that while her co-op doesn’t have any big immediate costs facing it, getting an added line of credit with the building’s new mortgage was “welcome.”

Should a co-op choose to refinance its loan at a lower interest rate and pay the old one off early, there is likely to be a gain that may not be obvious: one-time tax deductions. Since interest paid off in advance is deductible, co-ops may be due for a one-year lump sum interest write-off. That deduction is made even bigger by a quirk common in co-op building loans: many 10-year loans call for a schedule of interest amortization based on a 25-year mortgage life with a balloon interest payment at the end.

That’s a big cost. But, as with Kahng’s building, Lipson says the lowered interest rates may justify refinancing in spite of the sometimes seven-figure penalties applied.

The Killers

Before considering such a move, though, Lipson says that co-op boards must not only figure out how much such a change will cost and how much would be saved, but it must also undertake a thorough review to determine what its future capital needs will be.

The amount of the penalties is dependent on the specific strictures written into the mortgage agreement. Generally, prepayment penalties divide into two categories: those focused upon yield maintenance and “5-4-3-2-1” agreements.

In Goodman’s words, yield maintenance penalties can be “formidable.” Weinstein says these terms can be “killers.”

Less restrictive are the “5-4-3-2-1” mortgages. Characteristically, this type of loan covenant calls for a penalty of 5 percent additional interest cost for early repayment in the first two years of the loan, 4 percent in the next two years, 3 percent in the fifth and sixth years, 2 percent in the seventh and eighth years, and 1 percent in the ninth and tenth years. These terms are negotiable and vary from loan to loan. Further, Weinstein points out, it’s sometimes possible to get the penalties knocked out entirely for the final three or even six months.

Understandably, since these penalties drop away as the loan nears its termination, a great many of the refinancing deals now taking place happen in the ninth or tenth years of ten-year deals. Spurring that is a fear that the current low interest rates are unsustainable and rates will soon be headed back up.

One might note, though, that was the general belief about rates 10 years ago as well.

===HABITAT SIDEBAR===
Losing to Win: Castle Village

Mortgages almost always come with prepayment penalties. Otherwise, borrowers and lenders would be at the mercy of each other’s whims, borrowers cashing in when rates are low, or lenders demanding repayment when they are high. Sometimes, however, interest rates are so low that the prepayment penalty is very small when compared to future savings. That’s when you want to refinance. Here’s how Castle Village made the hard choice and came out ahead.

In 2003, the board of Castle Village, a 550-unit cooperative above the Hudson River in Upper Manhattan, took out a $25 million, 10-year mortgage that rebuilt the reserve fund and paid for work on elevators, roofs, parapets, terraces, exterior brick walls, and a 75-foot retaining wall. In 2005, a section of that stone retaining wall collapsed. After rebuilding, Castle Village’s reserves were down to virtually zero, and the co-op had significantly borrowed against its line of credit to pay for an onerous but necessary special assessment.

In 2012, the newly elected board examined its financial position: capital needs had been deferred because of the wall collapse and necessary rebuilding. Further, the building’s existing mortgage was coming due in fall 2013. “Luckily for the co-op,” says Andrew Ditton, the treasurer at Castle Village, “interest rates were at historic lows.”

Based on the low interest rates, Castle Village’s deadline-influenced need to refinance, and the need for additional capital to replenish reserves and pay for future expenditures, the board decided in spring 2012 to refinance that summer. In late July, when the board was ready to refinance, the commitment issued by NCB was at a record low rate.

It was clearly the best time to refinance, despite the prepayment penalty on the co-op’s existing mortgage. “Weighed against the potential for interest rates to go up, the penalty, which was a little over $100,000, would still be less than an increase of even 50 basis points,” Ditton says. “We looked at the co-op’s needs and at current interest rates. Based on these factors, refinancing in July 2012 made the most sense.”

After refinancing, the co-op had a new mortgage that netted about $11 million and kept the debt service portion of its maintenance payment flat, even after paying off the existing mortgages and making the prepayment penalty, and locked in this financing for 10 years. “The savings were huge,” Ditton observes. “Moreover, interest rates began increasing again, and were much higher the next year, when the board would have originally had to refinance.” Making the right decision at the right time certainly paid off for Castle Village.

– Meave Gallagher, with reporting by Tom Soter