Bridging the gap between flexibility and predictability


By Rushi Shah

Investors buying commercial mortgage-backed securities (CMBS) bonds pay for predictability of interest income. Commercial real estate borrowers, on the other hand, want the benefit of low‑priced, fixed‑rate, long‑term non‑recourse money, but with the flexibility to refinance or sell the property when their business goals or the market changes.

Commercial real estate lenders are able to serve both masters by baking prepayment mechanisms into CMBS loan docs that can release the borrower from the mortgage lien before maturity, while still delivering the same expected yield to investors for the term of the bonds.

There are two types of prepayment structures: Yield maintenance where borrowers pay a penalty, and defeasance, where the property is substituted with equitable collateral. Borrowers typically can’t choose between the two, and except in the case of larger loan amounts, terms are not normally negotiable. Prepayment may also be restricted to certain dates or only after a set number of years of payments. An experienced intermediary can explain which lenders’ policies are more “borrower favorable.”

PREPAYMENT STRUCTURE 1: Yield maintenance penalty
Through yield maintenance, the lender charges the borrower a penalty on top of the outstanding loan balance to cancel the mortgage note. The goal of the penalty is to make up the difference between what investors would have received in yield if the loan was held until maturity, and what it would cost them today to reinvest in a safe bond with a similar maturity that will generate the same expected cash flow. This is usually calculated by multiplying the present value of the remaining loan payments by the difference between the loan rate and the rate for a U.S. Treasury bond at the time of prepayment. Most lenders set the minimum penalty at 1 percent of the outstanding loan amount.

In Defeasance, the borrower (at his or her expense) replaces the collateralized property with similarly cash‑flowing collateral such as U.S. Treasury bonds or other securities (can be negotiated by an experienced intermediary) in order to cover the remaining principal and interest due on the loan through maturity. The mortgage lien is released, but the original debt obligation stays in place. The substitute collateral is held by a special entity known as a Successor Borrower.

Q. Which prepayment penalty structure is better for borrowers?

Hindsight is 20/20, as market conditions at the time of prepayment will drive what exit strategy is better for the borrower, yet the terms are defined at origination. CMBS lenders prefer defeasance because the burden is put on the borrower to spend the time and money to replace the collateral without interrupting investor cash flows. This translates into better ratings, more investor demand and higher prices for CMBS bonds that include the defeasance prepayment structure.

On the borrower side, both structures can be favorable. Because mortgage rates are always higher than U.S. Treasury rates, with yield maintenance a borrower could prepay for “free” (subject to any minimum fees) when interest rates rise enough to make up the spread between the current U.S. Treasury/reinvestment rate and the original loan rate.

For a defeasing borrower, when interest rates are higher than the loan rate, the substituted collateral will have a higher rate of return than the original loan, making it less expensive to do the swap. However, when current interest rates are lower than the coupon rate on the original loan, in addition to purchasing the collateral, the defeasing borrower must also pay a premium to cover the shortfall.

While there is no minimum premium amount, in either rate environment defeasance is a complex process and hefty third‑party administrative fees will apply. Your financing intermediary and attorney should outline all of the possibilities so you are prepared before you sign.

Q. Is there a way to sell my property without prepayment penalty?

Unlike loans through banks or other balance sheet lenders, CMBS loans are assumable. For a 1‑percent fee (your intermediary can negotiate a lower fee, especially for larger loan amounts), the purchaser can take over or “assume” the loan as‑is. The original borrower is released, and the new purchaser is now obligated to continue paying down the loan. The seller avoids pre‑payment penalties, and if rates rise or credit tightens, can attract buyers with better‑than‑market rates and terms.      ■

Rushi Shah is an executive vice president at commercial mortgage banking firm Aries Capital, LLC, and president of its online non‑recourse platform LendingCap Commercial. Since 1991, Aries has arranged/funded over $5 billion in financing in the U.S. and Caribbean. Shah held previous positions at Northern Trust. A member of AAHOA’s Strategic Business Advisory Committee, Shah holds an MBA from The University of Chicago’s Booth School of Business.


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