Yield Maintenance vs Defeasance for Real Estate Investors
Nearly all commercial real estate transactions are financed with some sort of debt. And, the terms of that debt – like interest rate, amortization, and monthly payment – can have a major impact on the returns generated by the property.
In this article, we are going to discuss two terms that relate to the prepayment penalty that can potentially be charged on a loan – defeasance and yield maintenance. We will define what they are, how they work, and how they impact investment returns. By the end, readers will have the information needed to incorporate these terms into their own pre-investment due diligence programs.
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Yield Maintenance vs. Defeasance
In order to understand Yield Maintenance and Defeasance, it is first important to understand how commercial real estate debt works – especially for larger loans.
When a commercial real estate lender makes a loan to a borrower/investor they don’t always keep it on their books. Sometimes, they will take the loan and pool it together with other loans and then sell securities against this pool to investors. When an investor buys these “commercial mortgage backed securities” or CMBS for short, they expect that they will earn a certain return on their investment.
Now, when a borrower takes on commercial debt, they don’t always pay it to maturity. In some cases they may choose to refinance the debt at a lower rate or in others they may sell the property. In both instances, they would need to pay off their original loan early. If/when they do and the loan is in a pool of CMBS, it will impact the return of the ultimate real estate investor who holds some or all of that debt. This is where Yield Maintenance and Defeasance come into play – they are both ways of calculating the prepayment penalty for paying off a loan prior to its scheduled maturity date.
What is Yield Maintenance?
Yield Maintenance is a type of prepayment penalty that allows CMBS investors to achieve the same yield as they would have if the loan was paid to maturity.
To calculate yield maintenance, there are two amounts to consider. The first is the unpaid balance of the loan. The second is the prepayment penalty, which is calculated by determining the present value of the remaining loan payments using a discount rate that is equal to the current yield on the US Treasury with a maturity closest to the loan’s maturity date.
The exact yield maintenance formula is defined in the yield maintenance clause of the loan documents so real estate investors should read it closely and make sure they understand exactly how it is calculated. If the loan is early in its term, a yield maintenance prepayment can be very expensive and could even cause a borrower to reconsider the prepayment of the loan.
What is Defeasance?
Defeasance is another type of prepayment fee that could potentially be incurred for paying off a loan balance early. With Defeasance, borrowers are required to replace their loan collateral with a basket of securities – usually fixed-rate Treasury bills – that will produce a return similar to the one the lender would have expected had the CRE loan been paid to maturity.
Again, the specific details of the defeasance calculation are outlined in the commercial real estate loan agreement so real estate investors should read them carefully to make sure they understand the consequences at the time of prepayment.
The Importance of Understanding Yield Maintenance and Defeasance
It is critically important that investors understand the concepts of yield maintenance and defeasance because they could play an important role in asset management decisions. Specifically, there are two instances where this may happen.
The first is in a potential sale. For example, suppose an investor purchases a property with debt that has a 10 year loan term. But, they timed it right and the market is hot and they get an offer that they can’t refuse five years into the holding period. To understand the true profit earned from the sale, they will have to weigh the sales price against the penalty for repayment of the loan early to determine if selling the property is worth it.
The second is refinance. On occasion, interest rates will fall enough that property owners can save a significant amount of money on debt service if they were to consider refinancing their debt. On its face, refinancing can be a no brainer, but investors must account for the penalty that comes with it. Once the defeasance or yield maintenance penalty is accounted for, the refinance calculus could change.
In both cases, the key is that investors must: (1) understand how the penalty is calculated and whether there are lockouts or prepayment dates; (2) calculate what the penalty is relative to the potential gain from sale or refinance; and (3) make a data driven decision based on this information.
Summary of Yield Maintenance vs Defeasance
Most deals for the purchase of a commercial real estate asset are financed with some amount of debt. Whether a CMBS loan or a portfolio loan made by a traditional lender, the debt holder has an expectation of earning a certain return on their investment.
But, things do not always go according to plan and there are times where a property owner/investor may have a good reason to pay off their loan early, particularly in the case of a sale or refinance. When this happens, borrowers may be charged a prepayment fee in the form of defeasance or yield maintenance.
Yield Maintenance is a type of prepayment fee that requires real estate investors to pay an amount based on the present value of the remaining payments on the loan and a predetermined interest rate – usually a US Treasury.
Defeasance is a type of prepayment fee that requires real estate investors to replace their loan collateral with a basket of securities – also US Treasuries – that will deliver a return that is similar to what the debt holder was expecting when the loan was made.
Details about how these fees are calculated are described in the loan origination documents so it is important for investors to read them and understand them as a basis for making key asset management decisions.
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