Financing Focus

What's Your Exit Strategy?

Borrowers should map out all options at the start of the loan process.

There are many factors to consider when entering into a fixed-rate commercial real estate loan; what’s often forgotten is how to get out. Negotiating a solid exit strategy should be a critical aspect of all fixed-rate loan originations. Proactive borrowers who invest the time to plan an exit strategy upon origination may find that they can minimize penalties later.

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 compensate for the lender’s reinvestment risk following prepayment. However, each method carries unique costs and implications, which can be punitive to a borrower.

At the highest level, yield maintenance and defeasance are prepayment provisions designed to protect the lender. Each allows the lender to realize the same yield as if the borrower were to hold the loan to maturity. However, yield maintenance entails the actual prepayment of a loan, whereas defeasance removes a property lien through a substitution of collateral and assumption of the loan by a third party.

Yield Maintenance

A prepayment in the more traditional sense, yield maintenance consists of a lump sum payment broken into two parts: the unpaid principal balance on the loan and a penalty. Because there is no standard language for the calculation of a yield maintenance penalty, it is especially important to examine these provisions when entering into a new loan. Typically, the penalty is calculated by discounting all future interest and principal payments back to the time of prepayment and subtracting the unpaid principal from the sum of these values. Yield maintenance penalties can vary greatly depending on the calculation method described within a given set of loan documents.

The severity of the penalty is based on two factors: the interest rate on the underlying loan and the replacement rate. The replacement rate varies directly with market rates at the time of prepayment, and most often it is the current yield on the U.S. Treasury that matures closest to the loan’s maturity date. The difference between the rate on the underlying loan and the Treasury rate represents the loss in yield that the lender will incur as a result of the prepayment if no penalty is paid.

Theoretically the prepayment penalty could be a negative number if the rate on the concurrent Treasury is greater than the loan’s rate. For this reason, yield maintenance provisions typically incorporate a minimum payment between 1 percent and 3 percent of the outstanding principal balance. This language puts a floor on the penalty that the lender will receive, making it an important exit term to consider when entering into a loan.

Defeasance

While yield maintenance is a purely economic treatment, defeasance is a legal and economic process. At its center, defeasance is the assumption of debt by a third-party sole-purpose legal entity, referred to as the successor borrower. The exit cost to the borrower is the price to purchase a portfolio of securities that will provide all of the future cash flows required under the original note. The borrower then transfers legal ownership of the securities portfolio to the successor borrower, and the lender transfers the lien from the original underlying real estate asset to the portfolio, releasing the borrower from the original loan.

Begin at the End

The right loan language can save borrowers a considerable amount of money in yield maintenance or defeasance costs. Because provisions often cannot be modified once loans are issued, borrowers must negotiate favorable terms at origination.

For yield maintenance, the basic rule is to have the replacement Treasury rate be as high as possible. Loan documents should not call for the replacement rate to be decompounded to a monthly rate. Treasury rates are typically compounded semi-annually and quoted as annual rates. Decompounding the replacement rate to a monthly rate serves to decrease the overall replacement rate and the subsequent discount rate used to calculate the yield maintenance penalty. A lower discount rate means a higher present value and therefore a higher penalty.

To further reduce future yield maintenance costs, loan documents can call for a basis increase to the prevailing Treasury rate. Typically this is achieved with language stating that “the replacement rate will equal the yield on the U.S. Treasury that matures on a date equal to the loan’s maturity plus [XX] basis points.”

Borrowers can reduce their future defeasance costs as well. Using federal agency securities, such as those issued by Fannie Mae and Freddie Mac, as collateral will result in the most cost-effective portfolio possible. However, specific language must be included in the loan provisions that define the replacement collateral as “government securities within the meaning of Section 2(a)(16) of the Investment Company Act of 1940.”

Another factor that reduces defeasance costs for borrowers is the ability to recoup a portion of any residual value in the defeasance collateral account once the loan matures. Residual value arises from a mismatch between the maturity and coupon dates of the defeasance securities and the loan’s payment dates. For example, a security may mature and pay into the collateral account on the 15th of the month while the loan payment is not due until the first. The funds sit in an interest-bearing account for 15 days to 16 days until they are used to make the mortgage payment. The interest earned cannot be used to make any debt service payments and cannot be withdrawn until the loan matures. This accrued interest can be significant, especially when the loan has a large balloon payment. Residual value is the sole property of the successor borrowers; however, original borrowers may realize a portion of this value if they enter into sharing arrangements with the successor borrowers.

In order for borrowers to ensure they receive a portion of the residual value, the loan documents should contain a provision that allows them to designate successor borrowers. While the sharing of this value does not decrease the upfront costs of defeasance, it does offer a rebate for borrowers either upon final payment of the loan or the present value of the projected residual value at defeasance closing.

If economically feasible, borrowers should include both yield maintenance and defeasance provisions in their loan documents at origination. This allows for maximum flexibility when exiting the financing. Although the final outcome is the same, penalties can differ by hundreds of thousands of dollars, depending on the method used. Including both provisions allows borrowers to make the most cost-effective choice.

Taylor Liska is a defeasance consultant at Chatham Financial. Contact him at tliska@chathamfinancial.com.

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