Wednesday, February 14, 2007
Yield maintenance and Defeasance
Most very attractive commercial financing over the last few years has been saddled with the burdens of yield maintenance or defeasance clauses. Essentially this is a prepayment penalty that does not go away, can be huge and can hinder the effective marketing of an investment property. Yield maintenance is simple - a formala is used to calculate what the prepayment penalty is based on the current market interest rates and the remaining term of the loan. This can be a large amount, but a seller can sell if he sees economic benefit. Defeasance is another difficulty all together - the loan cannot be retired, period. Companies such as Capital Defeasance Group provide the solution. The loan is removed from the property, the seller can sell unencumbered, the loan is then replaced to the lender by a portfolio of fixed rate income products (treasury notes and bills) which continue to pay down the loan according to schedule. Simple right? Actually yes, just difficult to explain without a powerpoint presentation. There definitely are significant costs involved. The upside is a property that CAN be sold.
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Although defeasance can be a bit complicated to understand, in terms of the loan being sold on the market and not "going away" as you said, the upside is that most are prepay penalty free after a certain short period. While you are still gambling on treasury rates, should you payoff, atleast the penalty is out of the way. Another attractive option I have found has worked in my clients' favor is assumability. I have bargained better terms on this one, and it has proved to be a win/win, in several instances, when the property was sold. In this respect, assuming one has shopped their loan around and the loan docs are well-read by trusted counsel or other experienced and qualified party, this type of financing can be quite effective. In my experience, I have chosen defeasance over YM the majority of the time. The options offered with this type of loan have best served my client. My advise is to get to know and understand how defeasance works. Once I got comfortable with understanding it, I saw the value it offered in larger deals, say 20M plus, in size. Thanks for your insight on the matter!
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