How does a defeasance prepayment penalty work?

What is a Defeasance Prepay Penalty?

Defeasance in commercial real estate loans allows borrowers to prepay by replacing the original property collateral with a portfolio of government securities that match the loan's payments. This process involves careful financial structuring to ensure the securities' cash flows cover all scheduled loan payments, transferring the risk from real estate to government-backed assets. While defeasance removes the property lien and maintains the lender's yield, it can be costly for borrowers due to the price of securities and various transaction fees.

How is a Defeasance Prepayment Penalty Calculated?

Calculating a defeasance prepayment penalty in real estate financing is a complex process that involves the creation of a portfolio of government securities, typically U.S. Treasury bonds, whose cash flows match the remaining payments of the original loan. Here's a simplified overview of the calculation process:

  1. Determine Remaining Loan Payments: Identify the remaining principal and interest payments on the existing loan according to its amortization schedule.
  2. Select Appropriate Government Securities: Choose government securities that have cash flows (interest and principal payments) aligning closely with the timing and amount of the remaining payments on the loan. The goal is to mirror the original loan's payment schedule as closely as possible.
  3. Calculate the Cost of the Securities Portfolio: The total cost of purchasing the selected securities forms the basis of the defeasance prepayment penalty. This cost reflects the present value of the future loan payments, and it varies based on current interest rates and the specific payment schedule of the loan.
  4. Consider Additional Costs: Beyond the cost of the securities, other expenses such as legal fees, consulting fees, and possible rating agency fees are also included in the overall defeasance cost.
  5. Adjust for Market Conditions: The calculation is sensitive to current market interest rates. If rates are lower than when the loan was originated, the cost of defeasance tends to be higher, as lower-yielding securities must be purchased in greater quantity to match the loan's payments.

This process makes sure the lender receives the equivalent economic value as if the loan had reached its natural maturity, protecting their expected yield, while allowing the borrower to effectively prepay the loan. The actual calculation can be very complex, and is usually conducted with the assistance of financial professionals specializing in defeasance transactions.

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