By Adam Karnes
Today’s commercial mortgage-backed securities (CMBS) loans are typically offered with the borrower’s choice of prepayment option: yield maintenance or defeasance. Both are designed to give the lender a “make-whole” for potential lost interest if the borrower chooses to repay the loan early. For example, he might decide to apply for a new loan to lock in longer-term financing at a lower interest rate or recapture equity; or he might sell his property.
Prepayment penalties are a necessity in commercial real estate lending. Here’s an explanation of why, as well as the pros and cons of each penalty type.
Planned Earnings
Through some combination of interest-rate yield spread, points charged up front or at maturity, and other fees, lenders plan to earn a certain amount of yield when they originate loans. They rely on prepayment penalties to ensure they (or the bondholder, in the case of CMBS) have the ability to earn the same yield as if the loan were carried until maturity.
On shorter loan terms, such as three to five years, the yield curve is fairly predictable, which means lenders are often comfortable with a more straightforward prepayment penalty, such as a simple step-down method. This is typically a percentage of the loan amount that steps down as the loan gets closer to maturity, say 3 percent, then 2 percent and then 1 percent.
On longer-term fixed-rate debt, the yield curve is much less predictable, and there’s a longer period during which rates can move. As a result, a more sophisticated penalty method is beneficial to the lender. If a 10-year loan is prepaid after six years, the lender would miss out on four years of interest payments. To compensate, the prepayment penalty provides the lender a lump sum that can be reinvested to maintain the same yield.
Yield Maintenance
Yield maintenance is a prepayment structure that typically consists of two payments: the outstanding principal balance of the existing loan and some predefined penalty. While the calculation provisions may vary from loan to loan, one benefit of yield maintenance is that it’s a fairly straightforward calculation.
One way to define yield maintenance is by calculating a replacement rate and multiplying it by the present value of the outstanding principal loan balance for the number of years remaining in the term. It’s necessary to calculate a replacement rate because once the outstanding principal is repaid, the lender can invest the proceeds in a low-risk asset such as U.S. Treasuries. However, the funds may need to be matched with other liabilities of the lender (i.e., the need to maintain yield).
At the time of writing, the five-year U.S. Treasury is yielding around 1.2 percent. This means that on a 5 percent mortgage-interest rate, there’s a 3.8 percent gap in yield that needs to be replaced. The bottom line is yield maintenance is much less complicated to execute than defeasance; it’s simply a mathematical calculation and requires only cash proceeds to pay off early. Once the conditions have been satisfied, the note is cancelled and the collateral released.
If owed, the yield-maintenance premium will generally be calculated by the lender’s mortgage servicer and included in the requested payoff quote. It may be beneficial to have an idea of how that number is calculated, which you should be able to replicate based on reading the definition in the loan document.
One disadvantage of yield maintenance is the loan typically features at least a 1 percent prepayment floor as a percentage of the outstanding balance. Because of the floor, the benefit to a borrower—which could be realized in a rising rate environment—is curbed. To calculate a replacement rate in the above example, the floor is irrelevant; but as the U.S. Treasury rate approaches the existing interest rate on the debt, the 1 percent floor comes into effect.
Defeasance
Defeasance is the actual replacement of the collateral that generates the stream in debt-service payments, most commonly with a portfolio of government securities. The word literally means “substitution of collateral.”
In defeasance, it’s the borrower’s responsibility to purchase the replacement collateral. This typically involves an agent or advisory firm that specializes in these transactions. Once a defeasance has been executed, the mortgage on the original collateral (the borrower’s property) is released from the lien and replaced with the defeasance collateral (government securities). Unlike in yield maintenance, where the note is actually terminated, a new security interest is perfected and the loan remains in place. The new portfolio of securities—often with varying maturities and coupons—re-creates the original debt-service payment stream at a 1.0 times ratio (plus some administrative fees).
One major advantage of defeasance is there’s generally no penalty floor. A scenario in which it may be beneficial is when the U.S. Treasury rates are higher than the existing loan’s contractual interest rate. In other words, if the securities have a higher yield, purchasing the replacement collateral may be cheaper, creating what’s known as a defeasance discount. If the replacement-collateral rates are below the existing loan’s interest rate (and with all other variables held equal), it seems logical that the cost to defease should be approximately the same as the cost of yield maintenance.
A major disadvantage of defeasance is the complication of acquiring the appropriate collateral; however, there are companies that specialize in providing this service at a fairly commoditized cost, which can include consultant, bond-trader, servicer and accountant fees. It may also include legal fees for the lender, borrower and successor borrower that will be established to hold the securities.
Defeasance is a longer process than yield maintenance and takes approximately 30 to 45 days. Therefore, it’s wise for the borrower to start discussion with a defeasance company when he begins working on his refinancing needs.
Depending on a self-storage owner’s investment goals, prepayment penalties can be a drawback to CMBS financing. Consider your long-term aims and weigh the pros and cons of each option. When in doubt, a professional can help you sift through the calculations and find the best solution for your particular situation.
Adam Karnes is a senior credit analyst for The BSC Group, where he specializes in the packaging of debt and equity financing requests for all commercial property types nationwide, with an emphasis on self-storage assets. Adam is based in Chicago. To reach him, call 312.878.7561; e-mail [email protected]; visit www.thebscgroup.com.
