Defeasance vs. yield maintenance: What's the difference?

Real Estate Issues, Summer 2001 by Schonberger, Michael, Moliver, Donald M

Defeasance is an attractive alternative to a yield maintenance formula that may provide a benefit to the borrower. While there is some administrative cost, including a possible additional prepayment fee, on balance, the potential gain far outweighs these costs.

Now that the commercial mortgages backed securities (CMBS) market is beyond the infancy stage, many in the industry have become familiar with the uniqueness of the loan origination process. For example, owners have come to recognize that to borrow from a Wall Street lender they must form a single purpose entity and agree to a capital improvement escrow account. Borrowers have also come to recognize that Wall Street regards prepayment fees as essential. One industry expert, in reflecting upon the reasons behind the growth in the CMBS market, continually identifies, "limited prepayment risk" as a leading cause.1 To the borrower, limited prepayment risk means enduring a lockout period, wherein it cannot prepay, followed by a period that prepayment is permitted subject to a significant fee.

Traditionally prepayment fees have been structured as either a declining balance or a yield maintenance formula. Wall Street lending offers a third option; call defeasance, which is rarely used by traditional lenders. This article will explain what defeasance is and how it works, and then compare it to a yield-maintenance formula in terms of cost. More specifically, this article will include:

* An overview of the practical and legal difference between a yield maintenance prepayment and a defeasance transaction;

* A hypothetical comparative example of the cost to prepay using a yield maintenance formula versus the cost to execute a defeasance; and

* The procedural steps necessary to complete a defeasance.

OVERVIEW

In the commercial mortgage market the prepayment fees are structured in a fashion whereby the lender receives nearly all of the benefits that are available as a result of declining interest rates. The borrower, however, may still be willing to prepay in order to take advantage of a market opportunity that will, or is perceived to, provide a benefit in excess of the prepayment fee. For example: sell the underlying property, a cash-out refinance, or a simply rollover refinance at a moment when rates are perceived to be at an unusually low point.2 In each of these cases, the prepayment fee becomes one of many transaction cost/benefit factors to consider. For purposes of this article, the benefit of a refinancing is assumed positive and, therefore, the analysis focuses on a comparison between the commonly used prepayment methods.

The earliest version of a prepayment fee is the declining balance formula. This formula is structured as a fixed percentage of the outstanding loan amount. For example, 5 percent in loan years one and two, 4 percent in loan years three and four, and so on until 1 percent in loan years nine and 10. As both the percentage reduction and a decreasing outstanding loan amount decline, so does the resulting fee. The concept behind this formula is that as a loan matures, prepayment will have a decreasingly smaller impact on the lender's profit. Declining formulas often included windows of 30-180 days prior to termination, wherein, the borrower could prepay with no penalty.

Later, the yield maintenance formula was introduced. Yield maintenance is a bit more creative in that the fee is based on interest rate movement. Therefore, a borrower seeking to take advantage of an interest rate decline would pay a higher fee than the borrower who prepays when rates have remained constant or have risen. The standard yield maintenance formula is defined as the present value of the remaining payments multiplied by the difference between the note rate and the treasury securities yield with the same term as the remaining term.3 The effect of this is to provide the lender, (or trustee in the case of a securitization), the ability to reinvest this lump-sum amount in treasury securities that will yield the same return as if the loan were in place to full maturity.

Later still, defeasance was introduced as an alternative to yield maintenance.4 Defeasance is a process whereby the borrower offers the lender replacement collateral in order to gain a release of the original collateral. In a securitized transaction, this replacement collateral must be treasury securities. Therefore, from a practical standpoint, yield maintenance and defeasance provisions are quite similar. Under the yield maintenance formula, the lender receives a lump-sum payment (based on treasury yields) that it can reinvest at will. In effect, a defeasement obligates the borrower to reinvest, on behalf of the lender, the prepayment proceeds in treasury securities.

From a legal standpoint, yield maintenance and defeasance are fundamentally different. Prepayment is the up-front payment of the outstanding loan balance, plus a prepayment fee in return for early note termination and collateral release. Since the note is terminated, the prepayment fee is considered to be a liquidated damage and therefore, when challenged, scrutinized under the "reasonableness" test. Defeasance, on the other hand is a collateral substitution. In a defeasance, the lender releases the lien on the original collateral and perfects a new security interest in some agreed replacement collateral (i.e. treasury securities). Throughout this process, the original note stays in effect with minimal or no modification. Since the note survives a defeasance transaction, there is no termination or liquidated damage issues. Courts will interpret defeasance as a prenegotiated contract option, which in general, is more likely to withstand a judicial challenge.5