CMBS Prepayment Terms

Summary

Defeasance

Defeasance is the substitution of collateral. Defeasance is used to calculate the cost of paying a commercial mortgage before the maturity date. Depending on market conditions, the borrower may incur a cost to defease a loan (going from a high rate to a low rate) or the borrower may receive a discount on the outstanding principal balance (going from a low rate to a high rate). When defeasance is used by the borrower, US Treasury bonds are purchased to substitute the cash flow of the borrowing entity (commercial real estate property) for the remainder of the term of the mortgage note when the borrower elects to pay the note (defeasance) before its maturity date.

Yield Maintenance

Yield maintenance is an actual payoff of the loan made up of two parts: the remaining principal balance on the loan and a prepayment penalty. The prepayment penalty applies because the borrower is paying off the loan prior to the maturity date; it allows the lender to attain the same yield as if the borrower had made all scheduled mortgage payments until maturity. The penalty is based on the difference between the interest rate on the loan and a specified reference rate (generally defined in the “NOTE”), and the remaining payments on the loan multiplied by this interest rate differential. The higher the borrower’s loan rate and the lower the current market rates, the greater the yield maintenance penalty. Unlike defeasance, there are no transaction costs associated with yield maintenance and the debt payments are paid off in cash instead of US Treasury securities.

Mathematically Explained

In a low interest rate market (like today), the borrower benefits with defeasance vs. yield maintenance.

For example: LOW RATE TO HIGHER RATE (Favorable to Borrower)

Hypothetically, moving from a rate of 6% to a rate of 8% = discount to the borrower

• Original Loan Amount: $5,000,000
• Amortization: 30 years
• Interest Rate: 6%
• Original Date of Note: May 1, 2004
• Date of defeasance: May 1, 2009
• Principal Balance at Defeasance: $4,677,404
• Discount with Defeasance from the Date the Loan was Initiated: $4,537,692
• Savings by Borrower: $139,712
• Result: If the borrower chooses to prepay or sells the property 5 years from the date the loan was initiated and the U.S. Treasuries increase from 6% to 8% as of 5/1/09, the borrower would receive a 3% discount on the principal balance or $139,712 savings.

External links

• Stursberg & Fine