Defeasance vs Yield Maintenance

Defeasance and Yield Maintenance are two forms of managing interest that are seen in the real estate market. They both have benefits and downsides, so it is a good idea for borrowers to learn about these systems so that they can make an informed decision.

What is Yield Maintenance?

Yield maintenance is the term that is used to describe the actual prepayment of a loan. A yield maintenance prepayment will typically consist of two portions. One portion is the unpaid principal balance of the loan and the other portion is a prepayment penalty, which is calculated using the value of the remaining loan payments. A discount factor is applied to that, and the discount factor is usually equal to the current yield on the U.S Treasury set to mature on or closest to the maturity date of the loan.

Yield maintenance loans are often appealing because they are simple and there are not any ‘hidden charges’. The only transaction fee typically associated with a yield maintenance loan is the processing fee that is paid to the entity servicing the loan. Since they are so simple, many borrowers opt for them even though in the long term opting for a loan with a yield maintenance clause could be more expensive.

What is Defeasance in Real Estate?

Defeasance is an alternative option to yield maintenance which can leave the borrower better off in the long term. Some people are put off from defeasance because there are more up-front costs. For example, there may be an administrative cost and an additional prepayment fee on the balance. In the long term, however, these fees will pay for themselves.

Commercial mortgages often use a defeasance formula. The industry has matured and a lot of borrowers re now aware of the issues surrounding prepayment. The limited prepayment risk issue is something that borrowers are acutely aware of. Traditionally borrowers are forced to endure a period where prepayments are not allowed, followed by another period in which prepayment is permitted, but there are significant fees to be paid which can make it ‘not worth’ prepaying.

Those prepayment fees would often be structured under a yield maintenance formula or a declining balance formula. Defeasance is a third option that traditional lenders rarely use, but that has some benefits for borrowers where it is available.

Why Would Anyone Prepay?

You may be wondering why anyone would want to prepay on a loan in the first place. Well, there are several reasons. Yes, it’s true that if someone has extra money and is likely to face prepayment fees, they would usually be best off putting the extra money into a bank account and sitting on it to let it earn interest, then paying off the loan when the fees are reduced.

The world doesn’t always work like that, however. A borrower might want to sell a property, or cash-out and refinance. They may even want to roll-over finance at a point when rates are lower than normal and they stand to save a lot of money. In these instances, it could be that the prepayment fee tips the balance as to whether refinancing or selling is financially viable.

Let’s assume that it is, in this case, and that the question comes down to how the prepayment fee is calculated.

Traditional Prepayment Fees

With the traditional method of calculating prepayment fees, the lender would use a declining balance. This uses a fixed percentage of the outstanding loan amount and may use a different percentage at different points in time. So, that could be five percent during the first year of the loan, four percent in the second, and so on until 1 percent in the final year.

Payments get cheaper as the loan period goes on because the outstanding balance is smaller and the percentage is smaller too. Often, in the last few months of the loan, there is no prepayment penalty at all.

Yield maintenance is a newer way of calculating prepayment fees that is based on the movement of interest rates. This means that there is an incentive for the borrower to time their repayment carefully. Borrowers who are hoping to take advantage of falling interest rates will find that the prepayments cost more during those periods, while a borrower who repays when interest rates are flat or are on the up will not be hit with such fees.

An Example of Defeasance

Defeasance is a different way of ‘prepayment’. Instead of paying off the loan and getting hit by fees, the borrower substitutes collateral. In the world of commercial real estate, a borrower replaces the real estate securing its loan with a portfolio of securities that will generate the same debt service as the original collateral would over the term of the loan.

Because the collateral has been replaced, the lien on the original property can be replaced. The defeasance process is time-consuming and complicated, and working out the defeasance period and the correct securities to substitute can be confusing.

Even so, defeasance has benefits. Lenders use defeasance to ensure that they have a ‘guaranteed’ income stream. Lenders don’t want people to pay their loans off early because that disrupts their steady income stream. Borrowers use defeasance because sometimes they do want to get out of a loan, and if they have the funds to pay it off early, then defeasance allows them to do that.

Defeasance can help to facilitate the sale or refinancing of a loan. The property owner pays off the commercial mortgage via defeasance, and is then able to sell on the property without transferring a lien to the buyer. The securities can be transferred to borrowers, and there is the opportunity for profit from the whole process. Typical examples of defeasance would use a very safe asset such as a U.S. Treasury bond, although some lenders may accept other securities.

Defeasance is complex, and it is a good idea to seek professional financial and legal advice before you start the process, to ensure that it goes smoothly.

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