Yield Maintenance vs. Defeasance in Commercial Real Estate
Yield Maintenance is a prepayment provision typically used in fixed-rate commercial loans. The key goal of yield maintenance is to ensure that the lender receives the same total amount of interest income over the life of the loan, even if the borrower decides to repay the loan early.
- Prepayment Fee: If the borrower repays the loan before the maturity date, they are required to pay a prepayment fee, which is often calculated to cover the present value of the future interest payments that the lender will lose due to the early repayment. This fee ensures that the lender is "made whole" by receiving the same economic return as if the loan had remained in place for its entire term.
- Calculation: The prepayment fee is usually based on the remaining balance of the loan, the remaining term, and the current market interest rates. It’s calculated using a formula that takes into account the difference between the loan's fixed interest rate and the prevailing market rates. If rates have fallen, the fee will likely be higher, as the lender will have to reinvest the funds at a lower rate of return.
Defeasance
Defeasance is another method of early loan repayment, but instead of paying a prepayment fee, the borrower effectively substitutes the collateral securing the loan with a portfolio of government securities (such as U.S. Treasury bonds) that produce cash flows equivalent to the remaining debt service. In essence, defeasance "defeats" the original loan by creating a substitute investment stream for the lender.
- Substitution of Collateral: The borrower purchases government bonds that generate income equal to the debt service payments remaining on the loan. These securities are then pledged to the lender, replacing the original property as collateral.
- Continued Payments The lender continues to receive regular payments from the government securities, which are structured to match the loan’s original payment schedule. This ensures that the lender is still receiving the same amount of cash flow from the loan, albeit from the bond portfolio rather than the property itself.
- Legal Process: Defeasance is typically more complex and involves legal and administrative steps to transfer the loan’s security from the property to the bonds.
Which is Better for Borrowers?
This choice depends on the specific needs of the borrower and the loan structure.
- Yield Maintenance might be the better option for borrowers who want a straightforward way to exit the loan early without engaging in complex transactions.
- Defeasance, while more complicated and potentially costly, could be advantageous for borrowers with larger loans or those who plan to refinance or sell the property.
Conclusion
Ultimately, the decision between yield maintenance and defeasance will depend on a variety of factors but mostly importantly the borrower’s business plan and the specific circumstances surrounding the property.
