What Lenders Want: How To Negotiate Better Prepayment Options

By Stephen B Weissman

Real estate lenders frequently use techniques known as a “yield maintenance prepayment premium” and “defeasance” to limit the financial risks they otherwise would face from prepayments of their loans.
A yield maintenance provision in a commercial loan document typically requires a borrower seeking to prepay a loan (perhaps to refinance at a lower interest rate or in connection with the sale of the property) to make a payment to the lender.  The amount of the payment would permit the lender to reinvest the funds received from the borrower, at the interest rate in effect at that time, so that it may earn the same amount of interest it would have earned had the borrower not prepaid its loan.  The amount of a yield maintenance payment in any particular transaction is a function of the market:  as interest rates go down, the premium goes up.
Another alternative used by lenders to allow prepayments by borrowers is known as “defeasance.”  Technically, defeasance is not actually a prepayment. Rather, it is a process whereby a borrower substitutes collateral for the real estate subject to a lender’s lien to enable the lender to maintain the same level of interest payments it would have obtained had the borrower continued to make payments according to the loan agreement.  The substituted collateral typically consists of Treasury securities.
Substitution of this collateral often is easier said than done.  A borrower interesting in defeasing must meet certain obligations under the loan documents.  For instance, it must pay processing costs, retain consultants to derive the appropriate mix of securities that must be delivered to the lender, and provide an opinion of counsel to the effect that the borrower has complied with all defeasance requirements under the law; these requirements can include Internal Revenue Service rules relating to Real Estate Mortgage Investment Conduits, if appropriate. In certain instances, rating agencies must evaluate the transaction and indicate that there will be no downgrading of the debt as a result of the defeasance.
Because a borrower that defeases through a substitution of collateral does not in actuality prepay its debt, concerns about prepayment penalties and other issues that might derail a prepayment penalty generally do not arise in defeasance scenarios. However, defeasance raises its own legal issues that have to be analyzed.
One of the most significant is the mortgage recording tax.  For example, New York tax law imposes taxes on the recording of a mortgage of real property in the state measured by the principal debt or obligation, which is, or under any contingency, may be secured at the date of the execution thereof or at any time thereafter. Lenders and their counsel had been concerned that assignment of a defeased loan might require payment of a mortgage recording tax. The New York State Department of Taxation and Finance has ruled, however, that a defeasance transaction can be structured to avoid payment of additional recording taxes.
For lenders, a key time to think about prepayment of commercial mortgage loans is when the original loan documentation is being negotiated.  Although courts have shown a willingness to enforce prepayment provisions, banks may be in a better position if their documentation requires yield maintenance payments or provides for defeasance.  In these situations, banks can be rather assured that their cash flow expectations will not be disturbed.

Copyright© 2003, Stephen B. Weissman. All right reserved. Stephen B. Weissman is a partner in Rivkin Radler LLP and the head of its Real Estate Practice Group. Stephen is based in the firm’s office in Uniondale, New York. For additional information,   contact the FrogPond at 800.704.FROG(3764) or email susie@FrogPond.com

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