In most commercial real estate transactions, debt financing plays a pivotal role in acquiring properties. Whether through CMBS (Commercial Mortgage-Backed Securities) loans or traditional loans, lenders expect to earn a certain return on their investment. However, life doesn’t always go as planned, and there may be instances where a property owner or real estate investor needs to pay off their loan earlier than anticipated—such as in the case of a sale or refinancing. When this happens, investors could face a prepayment penalty, which is typically in the form of yield maintenance or defeasance. Let’s take a closer look at these two methods, how they work, and how they can impact your real estate investment decisions.
What is Yield Maintenance?
Yield maintenance is a prepayment penalty that ensures lenders earn the same return on their investment as if the loan had been paid off according to the original schedule. This penalty is designed to make up for the lost interest payments the lender would have received if the loan had reached maturity.
To calculate yield maintenance, two key figures come into play: the remaining loan balance and the prepayment penalty. The penalty is determined by calculating the present value of the remaining payments on the loan, using a discount rate that’s typically set to the yield of a US Treasury bond that matures closest to the loan’s original maturity date.
The yield maintenance formula is usually outlined in the loan documents, so it’s critical for investors to review and understand how it is calculated. If the loan is early in its term, this penalty could be particularly costly, and it may even make an investor reconsider paying off the loan early.
What is Defeasance?
Defeasance is another form of prepayment penalty, but instead of a direct payment, the borrower must replace the loan’s collateral with a basket of securities—typically fixed-rate US Treasury bonds. These securities must generate a return that mirrors what the lender would have received if the loan had been paid off on the original schedule.
Like yield maintenance, the details of how defeasance is calculated are typically outlined in the loan documents. It’s important for investors to understand these terms, as the consequences of defeasance can be substantial when paying off a loan early.
Why Understanding Yield Maintenance and Defeasance Matters
Understanding how yield maintenance and defeasance work is crucial for making informed asset management decisions. These prepayment penalties can significantly affect the financial outcome of selling or refinancing a property.
- When Selling a Property: If an investor has held a property for several years, they might receive an attractive offer to sell. However, if the property is still under a loan with yield maintenance or defeasance provisions, they’ll need to weigh the sale price against the prepayment penalty to determine whether selling the property will still be profitable. The penalty can sometimes reduce the profitability of the sale, so it’s important to consider it in the overall financial picture.
- When Refinancing a Property: Refinancing a loan to take advantage of lower interest rates can be a smart financial move. However, it’s important to remember that paying off an existing loan early could trigger a prepayment penalty, which might offset the savings gained from a lower interest rate. Investors need to factor in these penalties when deciding if refinancing makes sense, as it could change the financial benefits of the transaction.
In both cases, investors should understand how the penalty is calculated, including any lockouts or prepayment dates, and then compare the cost of the penalty with the potential gains from selling or refinancing. By doing so, they can make a more informed, data-driven decision.
Conclusion
In commercial real estate, paying off a loan early—whether due to a sale or refinance—can trigger a prepayment penalty, either through yield maintenance or defeasance. Yield maintenance requires the borrower to pay an amount based on the present value of the remaining loan payments, typically using a rate tied to US Treasury bonds. Defeasance, on the other hand, involves replacing the loan’s collateral with a basket of securities that mirrors the original loan’s return expectations.
Both methods aim to ensure the lender is made whole, but they can add significant costs to an early loan payoff. As part of due diligence, it’s essential for investors to understand how these fees are calculated, so they can properly assess the financial impact when making key decisions about selling or refinancing properties.
