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.
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
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
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.
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
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
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 firstname.lastname@example.org.