Understanding Prepayment Penalties and Defeasance Fees

Real Estate

A very active market, combined with low interest rates, generates tremendous opportunities for commercial real estate owners to sell or refinance their properties.

However, the early extinguishment of debt can come with additional complications. Commercial real estate investments that have fixed-rate mortgages often come with prepayment penalties if the owners choose to pay off the debt ahead of its specified maturity date. These types of mortgages have generally been securitized and sold to investors as Commercial Mortgage Backed Securities (“CMBS”). CMBS rely on a stable payment stream through the original maturity date of the mortgage bundle. Thus, fixed-rate mortgages represent a more volatile investment because, in the event that a loan is repaid early, there is a risk that the resulting funds will be reinvested at a lower rate, resulting in an economic loss to investors. To counter the risk, lenders will often require the receipt of prepayment penalties. In some cases, the borrower will be required to pay the entire remaining interest on the note at the time that the debt is repaid. However, in many instances, the terms of the loan will call for a defeasance, which is effectively a prepayment penalty, but that can offer some flexibility to the borrower.

A defeasance is a transaction that allows the borrower to replace the collateral on the loans with assets that provide the same cash flow stream to the lender as the original loan. Generally, the new collateral is a portfolio of government securities, such as Treasury bonds. In exchange, the lender releases the real estate from the lien of mortgage. The terms of the defeasance will likely require a successor borrower to acquire the note and related collateral to assume the borrower’s obligation on the loan. This is beneficial to the lender because they maintain the same cash flow, and their investment is backed by lower-risk collateral, among other factors.

Whether a defeasance is advantageous to a borrower depends greatly on current interest rates.If interest rates are low and the rate on the debt exceeds the average rate on government securities,the borrower’s cost to acquire the securities will exceed the principal on the loan, since enough securities have to be purchased so that they yield the necessary income to service the debt. This is a defeasance premium, and can be quite costly. In addition, the borrower will incur other expenses, such as accounting and legal fees, consultant fees, as well as loan servicers, successor borrower fees, etc. Even in those circumstances, the overall costs of the defeasance may still be lower than a regular prepayment penalty.

From a tax standpoint, prepayment penalties, as well as the premium and expenses related to the defeasance, are deductible. However,in the case of a defeasance transaction,the timing of the deduction will depend on whether the borrower’s liability has been fully discharged. If the borrower retains any liability on the original note, then all expenses will be deductible over the remaining life of the note. However, if the debt is fully discharged, the borrower can claim the deduction in the year that the defeasance occurs.

Understanding the factors and intricacies of prepayment penalties and defeasance transactions is very important when negotiating the terms of a loan, and when analyzing the profitability of a sale or are finance. With the appropriate planning at various stages of the transaction, real estate owners can achieve their investment goals while minimizing their costs. Due to the complexities of the above, it is prudent that any potential borrower seek professional advice before finalizing any transactions.

Author: Kelly Lopez Portillo, CPA | [email protected]

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