The real estate market is growing and changing by the day, and today, it’s worth over $226 billion. There is a lot of potential but also there are risks involved for both lenders and borrowers. If you don’t have previous experience and deep knowledge, the chances of making a costly mistake can be high.
The real estate market offers two main ways of dealing with interest on loans, defeasance and yield maintenance. They both have their own good and bad sides, so borrowers should become educated on these topics to make an informed decision.
What is yield maintenance?
Yield maintenance refers to the actual prepayment on a loan. A yield maintenance prepayment consists of two portions—the unpaid principal balance and the prepayment penalty. The latter is calculated using the remaining loan payments. This is subject to a discount factor. The discount factor is typically equal to the U.S Treasury yield set to mature at or near the maturity date of the loan.
Yield maintenance loans can be attractive because they are easy to use and don’t have hidden fees. This type of loan typically has only a processing fee, which is usually paid to the entity that serviced the loan. They are simple enough that many borrowers choose them, even though a loan with a yield maintenance clause might be more costly in the long term.
Understand how yield maintenance works
A borrower can obtain financing by issuing bonds or taking out a loan (e.g. mortgage, auto loan, and business loan). The lender receives interest periodically as compensation for their use of the money over a certain period. Lenders project earnings based on the expected rate of interest.
An investor might purchase a 10-year bond at a $100,000 face price with an annual coupon rate of 7%. The investor will be credited annually at 7% x $100,000 = $7,000. A bank that approves a $350,000 loan at a fixed rate will expect to receive monthly interest payments until the borrower makes the mortgage payments.
There are some situations where the borrower makes a payment early on the loan or calls in the bond before the maturity date. This is a prepayment danger. In financial lingo, prepayment means that a debt is paid or an installment loan is paid off before the due date. It is a risk that every debt instrument has and that every lender must face, in some way. Lenders may not get their interest income stream for the same period they had hoped.
What is defeasance?
As its name implies, defeasance is a way to reduce the fees when a borrower prepays a fixed-rate commercial property loan. The defeasance option lets the borrower exchange another cash-flowing asset in return for the original collateral of the loan.
The collateral is generally less risky than the original commercial property assets. This scenario is a win-win situation for the lender. It receives the same cashflow, and in return, receives a better, more risk-adjusted investment.
The lender always reaps the benefits of defeasance, but borrowers also have the potential to benefit. In case the interest rate on loans rises, borrowers can create value and have cash available for prepayment.
Debtors should consider defeasance when negotiating a commercial property loan. This is to preserve the opportunity to create value and put cash in their pockets at prepayment.
Explanation for defeasance
Variable-rate commercial realty loans are a good way to finance short-term needs like construction or bridge financing. This capital loan is given to real estate owners during the lease-up phase and is repaid once the property yields cash flow.
While the interest rates risk is very high and there are no financial upsides, some borrowers will choose to finance long-term at variable rates. This is often when a property that has cash flow will likely be sold before the loan matures, or refinance in a short time period where expected interest rates are low.
Variable-rate financing is used by many borrowers to avoid the prepayment penalties lenders impose on prepayments for fixed-rate debt. Lenders do not have to take reinvestment risks when they finance variable-rate loans because the rates are regulated by the market. The funds can be repaid at the market rate.
Every borrower needs to be aware and well-informed of the different prepayment options in order to make the right financial decision. Now that you know what defeasance is and yield maintenance, you have the basic knowledge that will help you get the best loan conditions possible.