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Yield Maintenance and Defeasance: A Complete Guide

In the world of commercial real estate financing, borrowers often encounter terms like yield maintenance and defeasance, especially when considering prepayment options for their loans. These mechanisms are designed to protect lenders from the loss of expected interest income when loans are paid off early. However, they come with distinct features, costs, and legal considerations. This blog post delves into the differences between yield maintenance and defeasance, focusing on their calculation methods, cost implications, legal and regulatory considerations, and strategies for negotiating their terms and open periods.

Calculation Methods:

1. Yield Maintenance

Yield maintenance is a prepayment penalty that allows borrowers to pay off their loan early in exchange for a lump sum payment. This payment compensates the lender for the loss of expected interest income. The penalty is generally calculated as the present value of the remaining interest payments, based on the difference between the loan's fixed interest rate and the yield on Treasury securities with a similar maturity to the remaining term of commercial mortgage-backed security (CMBS) loans.

2.Defeasance

Defeasance, on the other hand, involves replacing the loan's collateral—usually the real estate property—with a portfolio of securities, typically U.S. Treasury or Agency securities, that generate enough cash flow to cover the remaining loan payments. This process effectively releases the borrower from the original loan obligations, allowing them to sell or refinance the property. The calculation of the securities portfolio needed for defeasance is complex and depends on current interest rates, the remaining term of the loan, and the cash flows required to service the debt.

Cost Implications

Defeasance generally incurs higher costs than yield maintenance due to the need to purchase a portfolio of securities, along with associated legal and administrative fees. The costs for both options can vary significantly based on the shape of the yield curve, the availability of higher-yielding securities (for defeasance), and any adjustments to the replacement rate (for yield maintenance). Additionally, yield maintenance might involve a 1-3% fee of the loan balance, while defeasance costs are influenced by the bid-ask spread and supply and demand for the bonds used as replacement collateral.

Legal and Regulatory Considerations

The legal framework for defeasance is dictated by REMIC rules, which outline the criteria for the collateral that can be used in the defeasance process. These rules ensure that the securities portfolio adequately secures the debt and mimics the cash flows of the original loan payments. Yield maintenance, while less complex, still requires careful consideration of the loan agreement's terms to ensure compliance with the calculation and payment of the prepayment penalty. Sponsors of hotels, apartments, industrial properties and office buildings are encouraged to contact Firstrealtycapital.net to ask questions about refinancing, hedging and negotiating the terms of their loans.             

Negotiating Terms and Open Period

When negotiating the terms of a commercial real estate loan, borrowers should consider the prepayment options available, including yield maintenance and defeasance clauses. It's crucial to understand the lockout periods, during which prepayment is not allowed, and the open periods, when prepayment options can be exercised. Borrowers may negotiate for shorter lockout periods or more favorable terms for yield maintenance or defeasance, depending on their financial goals and the anticipated holding period for the property. These are part of the services we offer to our clients.

 Conclusion

Both yield maintenance and defeasance offer pathways for borrowers to prepay their commercial real estate mortgage loans, but they come with distinct costs, calculations, and legal considerations. Understanding these differences is crucial for borrowers to make informed decisions that align with their financial strategies. By carefully negotiating the terms and considering the implications of each option, borrowers can optimize their approach to managing their commercial real estate loan.

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