Decoding Commercial Mortgages: Understanding Yield Maintenance vs. Defeasance

Apr 19, 2024

When it comes to commercial real estate financing, understanding the nuances of commercial mortgages is crucial for making informed decisions. Two key concepts that borrowers and investors should be familiar with are yield maintenance and defeasance. These are prepayment penalty methods that are used to compensate lenders for the loss of interest income when a borrower pays off a loan early.

Yield Maintenance

Yield maintenance is a prepayment penalty that ensures the lender receives the same yield as if the borrower had made all scheduled mortgage payments until maturity. This means that the borrower is responsible for paying the present value of the remaining loan payments, discounted at the current Treasury rate. The goal is to protect the lender from the loss of anticipated interest income.

Yield maintenance is often used in conjunction with fixed-rate loans and is considered a more straightforward method for calculating prepayment penalties. Borrowers should be aware that yield maintenance can result in substantial costs if interest rates have decreased since the loan origination.

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Defeasance, on the other hand, involves the substitution of collateral for the loan. The borrower purchases a portfolio of US government securities, typically Treasury securities, and transfers them to a special-purpose entity. These securities generate cash flows that are used to service the remaining mortgage debt, effectively replacing the original collateral.

Defeasance is often used with securitized loans, such as those that have been packaged into commercial mortgage-backed securities (CMBS). While the process can be complex and requires legal and administrative expertise, defeasance can offer borrowers the flexibility to prepay their loans without incurring significant penalties.

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Considerations for Borrowers

When evaluating commercial mortgage options, borrowers should carefully consider the implications of yield maintenance and defeasance. Factors to take into account include:

  • The type of loan and its associated prepayment terms
  • The current interest rate environment
  • The potential impact on cash flow and investment returns

Additionally, borrowers should consult with financial and legal advisors to assess the best strategy for managing prepayment risk and optimizing their financing arrangements.

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Decoding the differences between yield maintenance and defeasance is essential for navigating the complexities of commercial mortgages. By understanding these prepayment penalty methods, borrowers and investors can make informed decisions when structuring their real estate financing. Whether seeking to minimize costs or maximize flexibility, having a comprehensive grasp of these concepts is key to achieving favorable outcomes in commercial real estate transactions.