Understanding Defeasance vs Yield Maintenance

Selling or refinancing a multifamily property before the loan term ends typically requires paying a prepayment penalty, like yield maintenance. Defeasance, however, offers an alternative that could be appealing based on an investor’s specific circumstances and current market conditions. However, defeasance for multifamily loans is a more intricate process compared to simply paying a prepayment premium.

Discover how defeasance operates and how it stacks up against yield maintenance.

What is Defeasance?

A defeasance clause is a provision in a commercial real estate loan agreement that allows the borrower to replace the property securing the loan with alternative collateral, usually a portfolio of U.S. government bonds, which generates comparable cash flows for the remainder of the loan term.

Defeasance is commonly used in real estate transactions with securitized loans, such as agency or CMBS loans. It serves a similar purpose to a prepayment penalty by compensating the lender—or in the case of a securitized loan, both the lender and the security investor—for the anticipated interest income lost when a loan is paid off early.

How Defeasance Works

A multifamily owner replaces the property that initially secured the loan with substitute collateral, which is structured to generate enough cash flow to cover the remaining mortgage payments. This collateral is typically composed of fixed-rate government-backed bonds, ensuring the lender that the bonds will produce the necessary cash flow.

The owner then transfers the replacement collateral to an entity known as a successor borrower, which takes on the debt obligations, allowing the original property to be released.

Whether defeasance is available depends on the terms of the borrower’s loan agreement. If defeasance is allowed, the agreement will generally specify requirements, including:

• The types of securities eligible for purchase as collateral—for example, whether the borrower can use securities from Fannie Mae and Freddie Mac instead of U.S. Treasury securities

• The procedure for purchasing the securities and whether the borrower can buy them directly or must involve a third party

• The lock-out period during which defeasance is not permitted

Defeasance vs. Yield Maintenance

Defeasance and yield maintenance are both options for a multifamily investor looking to exit a loan early, but they have some key differences:

• Yield maintenance: When a borrower pays off a loan early, they must pay a premium in addition to the remaining principal. The yield maintenance premium is typically the higher of 1% of the principal being repaid or the premium calculated using the following formula: Yield maintenance premium = present value of remaining mortgage payments * (interest rate – Treasury yield)

• Defeasance: The loan remains active until it matures, meaning there’s no prepayment penalty. Instead, the cost is primarily determined by the value of the securities purchased as replacement collateral.