Understanding yield maintenance
Summary
Both yield maintenance and defeasance allow borrowers to unencumber the underlying real estate asset. From a legal and economic perspective, the two processes are fundamentally different.
What is yield maintenance and how does it differ from defeasance?
Both yield maintenance and defeasance allow borrowers to unencumber the underlying real estate asset. However, from a legal and economic perspective, the two processes are fundamentally different. Yield maintenance is the actual prepayment of the loan. Defeasance, on the other hand, entails a substitution of collateral and assumption of the loan by the successor borrower.
A yield maintenance prepayment usually consists of two portions:
The loan’s unpaid principal balance
A prepayment penalty – this is typically determined by calculating the present value of the remaining loan payments, with a discount factor equal to the current yield on the U.S. Treasury that matures closest to the loan’s maturity date
The only transaction fee associated with yield maintenance is a small processing fee to the loan servicer. In contrast, the cost of defeasance is determined by the price of a portfolio of bonds that are sufficient to provide for the remaining loan payments, plus transaction fees to several third parties. For borrowers, yield maintenance is generally simpler and less time-consuming than defeasance.
Chatham’s online Prepayment Calculator is designed to give an estimated prepayment penalty for the specified loan. It is designed for use with fixed-rate, U.S.-denominated debt based on the general assumption that the prepayment premium equals the greater of the minimum penalty, or the present value of all scheduled future debt payments (after the prepayment date) discounted at a treasury yield, less the principal repaid.
Important note
The Prepayment Calculation is only an estimate – specific debt prepayment provisions are not considered in the calculation. The results should not be used as a precise indication of the Yield Maintenance Costs but rather as a guide to help inform a decision as to whether prepayment is a viable strategy for a borrower.
Chatham Financial has executed over $186 billion total principal defeased, and returned over $225 million in residual value to borrowers. Defeasance consultants are a part of Chatham’s global real estate financial risk management practice, solving common but complex capital markets challenges for commercial and multifamily real estate investors.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit cf.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.
