Yield Maintenance vs. Defeasance
One thing that most borrowers do not understand as much as they should is the difference between the various prepayment options. A typical CMBS loan will include the option to prepay by “defeasing” the loan. However, yield maintenance is almost always an available option. What is the difference and how should I choose?
First off, how about some simple definitions:
Defeasance requires a borrower to acquire a series of US government securities to be held in escrow such that each remaining loan payment to and through maturity is made by a payment of those securities. The good thing about defeasance is no minimum payment is required under defeasance. Additionally, in a rising interest rate environment, it is possible to receive a premium when defeasing a loan rather than requiring a capital outlay (ie. No prepayment penalty). The bad news about defeasance is that a borrower must hire a firm to acquire the defeasance collateral and there is typically a legal and administration fee charged by the firm.
Yield maintenance is a simpler option than defeasance and requires no fees. Prepayment under yield maintenance requires a premium paid in excess of the loan balance. That premium is calculated by applying a discount rate to the remaining payment schedule. The discount rate is typically the yield on a US government security with a term remaining equal to the remaining term or average life of the loan. The good thing about yield maintenance is that it is a simple calculation and there are no third-party services to engage or fees to pay. The bad news about yield maintenance is that there is typically a minimum premium to be paid by the borrower regardless of the outcome of the yield maintenance calculation, usually 1%. Additionally, unlike defeasance, the outcome of the calculation will never result in an excess premium being paid back to the borrower.
A few simple examples:
Let’s say that I closed a $10 million, 10-year loan on June 1, 2016 with a 4.0% rate and 30-year amortization. Let’s assume that I want to prepay this loan after three years in two different interest rate scenarios and look at the outcomes:
Rising Rate Scenario:
First, let’s assume the 7-year interest rate (the remaining term in three years) increases to approximately 5%.
I used the defeasance calculator at www.defeasewithease.com to estimate the defeasance cost. Because the rates increased, the borrower would receive a premium at the time of payoff of approximately $717,000. The estimated costs for legal and administration total $68,000, but a borrower would pocket nearly $660,000 at the time of the prepayment.
If I run the same calculation under a yield maintenance scenario, the premium calculated would return approximately $516,000 to the borrower, however, because your loan documents most likely require a minimum prepayment premium paid by the borrower of 1%, you will owe the lender a 1% premium, which works out to about $95,000.
In this scenario, defeasance is clearly the winner with a delta of $755,000.
Flat Rate Scenario:
As a second scenario, let’s assume rates remain flat with where they are today.
Under a defeasance scenario, the premium comes to just over $2 million paid by the borrower with another $68,000 in administrative costs.
Under a yield maintenance scenario, the premium is about $1.5 million.
In this scenario, yield maintenance is clearly the winner.
What’s the lesson learned? In a rising interest rate environment, defeasance may be the better option. Why not ask your lender whether they’d consider allowing you the option to choose whether to defease or prepay with yield maintenance at the time of prepayment? Some lenders will allow this option, but not all. I’ve closed several large CMBS loans with this option.