Treasury Yields Create Defeasance and Yield Maintenance Nightmare
December 11, 2008
Treasury yields have plummeted to near nothing, and in some cases they have even gone negative for the first time as investors are searching frantically for the financial equivalent of a panic room.
To commercial real estate owners who are looking to sell, or refinance, this has created yet another problem, the issue of maintaining yield or defeasing a commercial loan in such a low interest rate environment.
Don’t know what Yield Maintenance or Defeasance is? They are essentially prepayment penalties which allow the lender to achieve the same yield they would have earned throughout the term of the loan, even if the borrower decides to sell, payoff, or refinance the loan early. A summary of the three most common penalties found in commercial mortgages are below:
- Prepayment Penalty: These are usually fixed amounts. For example, a loan with a 10-year term may have a prepayment penalty of 3% if it is paid off in the first 2 years, 2% in the next 3 years, and 1% in the remaining 5-9 years, and no penalty in the last year.
- Yield Maintenance Penalty: This is a penalty which is calculated by taking the present value of the remaining payments, and multiplying it by the difference between the note rate (mortgage rate) and a pre-determined treasury security (for instance 5-year treasury). In other words, you will pay the lender the amount of money needed to make up for what they lost when you paid off the loan early.
- Defeasance: This is similar to yield maintenance, but more complicated and expensive. What happens during Defeasance is that the loan is not paid off; instead a seperate entity/company is created and substituted for the borrower. The company which is created is responsible for one thing only, and that is making payments as if the borrower was still on the loan. The borrower’s penalty is what is called the Defeasance Deposit, the amount of money the buyer needs to spend to buy the necessary basket of securities/treasuries needed to service the payments of the mortgage. Once the securities are in place, then the borrower is essentially out of the picture.
The creation of commercial mortgage-backed securities (CMBS) caused a large spike in the number of loans which utilized Yield Maintenance and Defeasance.
Prepayment penalties are no mystery, they are fixed and thus are known from day one. With Yield Maintenance and Defeasance however, the prepayment penalty is subject to interest rate activity, and therefore can vary widely. The security most often used to calculate these payments are US Treasuries (though in some cases, for example Fannie Mae loans, Fannie Mae securities may be used).
In today’s market where Treasuries are yielding historic lows, the prepayment penalty that can result from Defeasance or Yield Maintenance requirements can be staggering, making it very undesirable for sellers to sell. If seller’s need or are forced to sell, then Yield Maintenance and Defeasance can make the situation even worse.
To quantify the difference, here are a few examples demonstrating how a borrower’s prepayment penalty has changed just over the course of the past six months.
For the sake of simplicity, let’s assume a $10,000,000 loan made on 01/01/2006, at an interest rate of 5%, with a term of 5-years, and a 30-year amortization.
Yield Maintenance Method: The current yield on a 2-year treasury security is about .81%. Hence, the Yield Maintenance penalty on this loan would be about $770,000.
Six months ago, the yield on a 2-year treasury was about 2.6%. The Yield Maintenance penalty on this loan would have been about $550,000, about $220,000 less, even though it would have been paid off 6 months sooner. A year ago, when rates were over 3%, the prepayment penalty would have been under $500,000.
Defeasance Method: Defeasance is essentially the same as Yield Maintenance, except that the administrative and servicing costs are higher, there is usually a lockout period, and it is a bit more difficult to calculate. The advantages of Defeasance however are that there is generally no minimum penalty (most Yield Maintenance loans have a minimum penalty of 1%), and that if interest rates move up, it is possible to actually get a discount at the payoff if the securities yield more than the mortgage rate.
Calculating the cost of defeasance is complicated, but the above loan would have about a $53K monthly payment, and a remaining balance of about $9.5M. Therefore, the Defeasance Deposit comes in about $950K. Shift the yield curve by 150 basis points, and the Defeasance Deposit drops to about $550K, giving you an idea of how interest rates have effected the cost of making the Defeasance Deposit. In addition, there is roughly $50K worth of expenses related to Defeasance.
The difference a few months have made in both scenarios is staggering. Take the difference and put it in the perspective of some of the larger transactions and the effect Treasury Yields will have on those sellers is significant, particularly those which might be forced to sell as a result of current market and credit conditions.
Similar Posts:
- Treasury Reworking Tax Rules to Help Dampen Commercial Real Estate Fallout
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- Government Expands Financial Stability Act to Include CMBS
- Taking Advantage of More Stringent Residential Lending Standards
- 3-Month Treasury Bill Yields Turn Negative
Tags: CMBS, Defeasance, Interest Rates, Investments, Mortgage, Prepayment Penalty, Treasuries, Yield Maintenance
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- Pingback by Treasury Yields and Commercial Real Estate | Peter Pays Paul on December 11, 2008 @ 1:31 pm
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great post! I haven’t read about this anywhere else. People are so focused on rents falling and tenants going out of business that they often times forget about a lot of the moving parts that happen when buildings are bought and sold.
I would really hate to be forced to sell anything right now. Between the lack of funds and things you discussed here, I’d probably just throw my hands up and walk away.
Great post. I work in the defeasance/commercial real estate finance industry and frequently provide cost estimates for both defeasance and yield maintenance transactions to commercial property owners/buyers all of the time. Borrowers routinely contact us to find out how much their defeasance or yield maintenance will cost and unfortunately in the current treasury yield environment these figures often become deal breakers. However, there are still deals with the provisions being completed. I would be more than happy to answer any further questions on this topic (rcampbell@chathamfinancial.com). Thanks again for the post!
A property owner that must sell a property can avoid these hefty penalties by having the new owner assume the existing loan. Typically this is done for a fee of 1% of the remaining balance of the loan. The lender must qualify the new borrower, but a 1% fee is much better compared to a 10% fee (using the defeasance example above).
I think the biggest positive to
Yield Maintenance
is the fact it cuts way down on flipping.
The commercial market has been hit- but not like residential- and I think Yield Maintenance has a lot to do with that