Choosing a Prepayment Option: Yield Maintenance vs. Defeasance

December, 2016

Today's CMBS loans are typically offered with the borrower's choice of prepayment options: Yield Maintenance or Defeasance. Both are designed to give the lender a "make-whole" for potential lost interest should the borrower choose to repay the loan early, which a borrower may find desirable to lock-in longer term financing at lower interest rates, recapture equity, or surrounding the sale of the asset. This article will explain each option and provide an assessment of the pros and cons of both. This should give readers a basic understanding of their options without overcomplicated explanations.

Why are prepayment penalties necessary in commercial real estate lending?

Through some combination of interest rate yield spread, points charged up-front or at maturity, and other fees charged, lenders plan on earning a certain amount of yield when they originate loans. Therefore, a lender relies on prepayment penalties to ensure that in the event a loan is paid off prior to its maturity date, the lender (or bondholder in the case of CMBS) has the ability to earn the same yield as if the loan were carried until maturity. On shorter terms such as 3-5 year loans, the yield curve is fairly predictable, which means that lenders are often comfortable with a more straightforward prepayment penalty, such as a simple step down method (typically a percentage of the loan amount that steps down as the loan gets closer to maturity, i.e. 3,2,1%) However, on longer-term fixed rate debt, the yield curve is much less predictable and there is a longer period of time during which rates can move, and thus a more sophisticated prepayment penalty method is beneficial for the lender. Consider that if a ten-year loan were prepaid after 6 years without a prepayment penalty, there are four years of interest payments that lender would not receive. To compensate the lender for this missed interest, the prepayment penalty is designed to provide the lender a lump sum that can be reinvested to maintain the same yield. The two most common types of prepayment penalty in long-term fixed-rate lending are Yield Maintenance and Defeasance, which are detailed below.

Yield Maintenance

Yield maintenance is a prepayment structure that typically consists of two payments, including: 1) the outstanding principal balance of the existing loan and 2) some pre-defined prepayment penalty. While the calculation provisions may vary from loan to loan, one benefit of yield maintenance is that it is a more straightforward calculation than defeasance. For the sake of example, one way to define yield maintenance is by calculating a replacement rate and multiplying that by the present value of the outstanding principal balance for the number of years remaining in the loan term. It is necessary to calculate a replacement rate for the following reason: once the outstanding principal is repaid, the lender can invest the proceeds in a low-risk asset such as US Treasuries, but the funds may need to be matched with other liabilities of the lender (i.e. the need to maintain yield). At the time of writing, the 5-year US Treasury is yielding around 1.2%, which means that on a 5.0% mortgage interest rate, there is a 3.8% gap in yield which needs to be replaced (5.0% - 1.2% = 3.8%), hence the term replacement rate. The bottom line is that yield maintenance is much less complicated to execute than defeasance; it is simply a mathematical calculation and only requires cash proceeds to pay off early. Once the yield maintenance conditions have been satisfied, the note is cancelled and the collateral is released.

If owed, the Yield Maintenance premium will generally be calculated by the lender's mortgage servicer and included in the requested payoff quote. It may be beneficial to have an idea of how that number is calculated and should be able to be replicated based on reading the definition in the loan document. One disadvantage of Yield Maintenance is that the loans typically feature at least a 1% prepayment floor as a percentage of the outstanding loan balance. Because of the floor on Yield Maintenance, the benefit to a borrower which could be realized in a rising rate environment is curbed. In the example above, to calculate a replacement rate, the floor is irrelevant, but as the US Treasury rate approaches the existing interest rate on the debt, the 1.0% floor comes into effect.

Defeasance

Another prevalent prepayment option is defeasance, which is the actual replacement of the collateral that generates the stream in debt service payments, most commonly with a portfolio of government securities. The word defeasance literally means "substitution of collateral". Unlike yield maintenance, with defeasance it is the borrower's responsibility to purchase the replacement collateral, and this typically involves an agent or advisory firm that specializes in defeasance transactions. Once a defeasance has been executed, the mortgage on the collateral (the borrower's property) is released from the lien and substituted or replaced with the defeasance collateral (government securities), all while the loan (the note) remains in place. This is a major difference from yield maintenance in that the loan is still in place after the defeasance and a new security interest is perfected, while the note is actually terminated in a yield maintenance scenario. The new portfolio of securities, often with varying maturities and coupons, recreates the original debt service payment stream at a 1.0 times ratio (plus some administrative fees).

One major advantage of defeasance is that there is generally no penalty floor on this method, so there are cases where it can be to the borrower's benefit to defease. The scenario where it may be most advantageous for defeasance is when the US Treasury rates are higher than the existing loan's contractual interest rate. In other words, if the securities have a higher yield, purchasing the replacement collateral may be cheaper, creating what is known as a defeasance discount. If the replacement collateral rates are below the existing loan's interest rate- and with all other variables held equal- it seems logical that the cost to defease should be approximately the same as the cost of yield maintenance. A major disadvantage is the complications of acquiring the appropriate defeasance collateral; however, there are companies that specialize in providing this service for borrowers at a fairly commoditized cost. These costs can include consultant fees, bond trader fees, servicer fees, accountant fees as well as legal fees for the lender, the borrower and the successor borrower that will be established to hold the securities. Defeasance is a longer process than yield maintenance and takes approximately 30-45 days, therefore it is wise to start discussions with a defeasance company at the same time the borrower is working on refinancing needs.

Additional Resources

As highlighted above, there are considerations for both defeasance and yield maintenance that should be addressed before making a decision and there are many websites available to help calculate the defeasance and Yield Maintenance provisions:

Adam Karnes is a Senior Credit Analyst for The BSC Group, where he specializes in the packaging of debt and equity financing requests for all commercial property types nationwide, with an emphasis on self-storage assets. Adam is based in Chicago, and can be reached at 312.878.7561; e-mail akarnes@thebscgroup.com; visit www.thebscgroup.com.

Articles: December 2016

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