Prepayment Lockout

Definition of Prepayment Lockout

A prepayment lockout is a restrictive provision in a commercial mortgage contract that prohibits the borrower from paying off the loan balance for a specific period of time. During this window, the lender will not accept early principal payments, effectively "locking" the borrower into the loan. This is most commonly found in Commercial Mortgage-Backed Securities (CMBS) and other institutional lending structures where predictable cash flows are required for investors.

Detailed Description of Prepayment Lockout

In commercial real estate finance, lenders and investors rely on the interest income generated over the life of a loan to achieve a specific yield. If a borrower refinances or pays off a loan early, the lender faces "reinvestment risk," meaning they may not be able to lend that money out again at the same high interest rate. The lockout period serves as a hedge against this risk by guaranteeing that the loan stays on the books for a minimum duration.

The lockout period typically occurs at the very beginning of the loan term. For example, on a 10-year commercial loan, a lender might impose a two-year or five-year lockout. Once the lockout period expires, the loan generally moves into a secondary phase where prepayment is permitted, but only if the borrower pays a penalty such as yield maintenance or undergoes defeasance.

Key features and considerations of a prepayment lockout include:

• Absolute Restriction: Unlike a prepayment penalty (where you can pay a fee to exit), a lockout is a legal prohibition. The lender is under no obligation to accept a payoff during this time.
• Yield Protection: The primary goal is to protect the lender's Internal Rate of Return (IRR) and ensure that the interest income remains steady for the duration of the lockout.
• Property Sales: If a borrower decides to sell a property while a lockout is in effect, they usually cannot pay off the mortgage with the sale proceeds. In these cases, the buyer must often assume the existing mortgage, or the seller must wait until the lockout expires.
• Standard Terms: Lockout periods are often expressed as a specific number of months from the date of the first payment (e.g., a 24-month or 36-month lockout).

Because of these rigid terms, prepayment lockouts require borrowers to have a clear long-term strategy. If a borrower anticipates needing to sell the property or refinance in the short term to pull out equity, they must negotiate shorter lockout periods or seek different financing structures that offer more flexibility, though often at the cost of a higher interest rate.