Investment Analysis Financing

Cost Comparison: A Case Study

When looking to extinguish fixed-rate debt, borrowers have two alternatives: yield maintenance or defeasance. Both methods allow the borrower to unencumber the underlying real estate asset, and both compensate for the lender’s reinvestment risk following prepayment. However, each method carries unique costs and implications, which can be punitive to a borrower.

A considerable advantage of defeasance over yield maintenance is that there is no floor. When the average yield on the substitute collateral is higher than the coupon on the loan, it is cheaper to purchase securities to cover the loan’s remaining interest and principal payments than to hold the loan.

Conversely, a drawback to defeasance is the complexity of the transaction and the required fees the borrower will incur. The process typically takes 20 to 30 days and can require $50,000 to $100,000 in legal fees.

The differences in cost between yield maintenance and defeasance is best explained with a hypothetical loan. Table 1 illustrates the loan terms and contemplates a defeasance or prepayment on Jan. 1, 2012.

Table 1

Loan Terms

Original balance

$100 million

Interest rate

5.0%

Type

Balloon

Amortization

30 years

Start date

Jan. 1, 2005

Maturity date

Dec. 1, 2014

Prepayment at par window

3 months

Prepayment or defeasance date

January 1, 2012

In this example, four scenarios are presented: favorable and unfavorable defeasance provisions and favorable and unfavorable yield maintenance terms. (See Table 2.) Interest rates were shocked both positively and negatively to show how the different prepayment costs would react.

Table 2

Defeasance and Yield Maintenance Terms

Defeasance

Yield Maintenance

Favorable

Unfavorable

Favorable

Unfavorable

Permitted to use agency securities as defeasance collateral

Must use U.S. Treasuries as defeasance collateral

Treasury rate is not decompounded to a monthly rate

Treasury rate is decompounded to a monthly rate

Permitted to purchase defeasance collateral that makes payments through any payment date within the prepayment window

Must purchase defeasance collateral that will make payments through the maturity date

Yield maintenance payments are calculated to the prepayment date instead of the maturity date with a minimum 1% penalty

Yield maintenance payments are calculated to the maturity date with a minimum 3% penalt

Based on rates as of Aug. 19, 2011 (10-year U.S. Treasury 2.10 percent; five-year U.S. Treasury 0.91 percent).

Table 3 illustrates the cost associated with either prepaying or defeasing based on the terms in the loan documents and the interest rate environment at the time of repayment. The table illustrates two key points: the cost differential between defeasance and yield maintenance given varying interest rates, and the importance of negotiating favorable terms at the time of loan origination.

Assuming the loan contains favorable defeasance provisions, it will always be cheaper to defease a loan with this structure. This is due to the ability to defease using federal agency securities (such as those issued by Fannie Mae or Freddie Mac) as replacement collateral and structuring the defeasance payments to the prepayment period rather than the loan’s maturity date. Yield maintenance (containing favorable terms) is the next least-expensive alternative for this loan in today’s interest rate environment.

Notice also that the yield maintenance penalty is linear until rates rise by 4 percent above today’s rates, at which time the minimum penalty kicks in. The defeasance cost is always linear as there typically is no minimum defeasance penalty. Therefore, as rates rise, defeasance becomes the best alternative regardless of the defeasance provisions the loan contains.

The answer is less clear-cut if rates are lower than the loan rate at the time of prepayment. With the exception of a loan with favorable defeasance terms, there is usually little difference in the prepayment premium.

Taylor Liska is a defeasance consultant at Chatham Financial. Contact him at (484) 731-0038 or tliska@chathamfinancial.com.

For more on yield maintenance vs. defeasance, read “What’s Your Exit Strategy?” in the Nov./Dec. 2011 issue of CIRE.

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