Question for investors closing new 5 year Agency fixed debt – have you considered the prepayment options and potential penalties? Electing yield maintenance (YM) adds 0.05% or less to the spread but can reduce the potential future prepayment penalty materially. Rate buydowns also help in a huge way. Here’s how.
Freddie Defeasance
Freddie fixed loans are often subject to defeasance by default. The lender has one year to securitize the loan (although this is usually done in the first month), the loan is subject to a two year lock out following securitization, the loan is eligible for defeasance from the end of lock out to the beginning of the open window, and borrower is eligible to prepay at par during the open window.
During the defeasance period, borrower is required to deliver a portfolio of securities (as part of the defeasance closing process) that provides for all remaining payments of principal and interest due under the Note, through Maturity, including the final balloon payment at Maturity.
If lender securitized the loan the day after closing, and borrower elected to defease the first day after the lockout ended, 3 years would remain on the loan meaning the portfolio would have 3 years of payments. It also means the penalty would be driven by the 3 year Treasury.
Freddie Yield Maintenance
If a Freddie fixed loan isn’t securitized within the first year or borrower pays up for the YM option, the loan is subject to YM. In that case, YM applies until the end of the YM Period (typically 3 months prior to maturity on 5 year loans), and borrower is eligible to prepay at par thereafter.
If borrower elected YM and prepaid 2 years after closing, 3 years would remain on the loan. However, Agency YM is only calculated to the end of the YM Period. If the YM period ends at the 3 month open window, then only 2.75 years would remain for purposes of the calculation. This means the interpolated 2.75 year Treasury would drive the penalty.
Defeasance vs Yield Maintenance
To help illustrate what electing YM does to the penalty, let’s look at both scenarios. Assume a new 5 year loan at the following terms:
Loan Amount $50,000,000
First Payment 8/1/2024
Maturity 7/1/2029
Index / Spread 5 year Treasury + 1.75%
Amort Interest only
The 5T at the time of writing was 4.25%, so for this example borrower would be fixed at 6.00% assuming defeasance and 6.05% if borrower paid up for YM.
Here are projected defeasance penalties with 3 years, 2 years, and 1 year remaining on the loan.
By way of example, if the loan is defeased 2 years from now (when 3 years remain), the penalty is estimated to be against borrower by $4.63mm assuming 3 year rates are around 3.00%. Conversely, if 3 year rates are around 7.00%, the penalty would be in borrowers favor around $700k. The latter is known as a negative defeasance penalty – more about negative defeasances here.
Here are projected YM penalties with 3 years, 2 years, and 1 year remaining on the loan.
If the loan is repaid 2 years from now, the penalty is estimated to be against borrower by $3.97mm if the replacement rate is around 3.00%. A $660K+ reduction! Conversely, if rates are near or above the 6.05% Note Rate, the penalty would be bumping up against the 1% minimum, or $1.2mm more than defeasance.
As previously mentioned, since defeasance is calculated through Maturity but YM is only calculated through the open window, we’d actually be looking to the 2.75 year Treasury yield for purposes of the YM calcs. However, we’re assuming the replacement rate is the same in this example.
Below we’ve included tables outlining how YM compares to defeasance both in dollar savings as well as a percentage of the loan balance.
Takeaways:
- When rates are lower, YM is expected to result in material savings.
- When rates are near or above the Note Rate, defeasance is cheaper due to YM having a 1% minimum.
- The shorter the remaining loan term, the more the 1% minimum comes into play.
- The 1% minimum under YM is the main trade off (and risk)!
Why does YM make more sense when rates are lower?
There are two main drivers of this:
- Prepayment penalties are a factor of time remaining, the difference between the Note Rate and replacement rate (with a tenor matching the end of the calculation), and the loan balance. By going with YM, the remaining term is shortened since the calculation only goes through the open window.
- Unlike YM, which is just math, defeasance penalties are also impacted by the efficiency of the portfolio and trading costs. Bond payments and maturities don’t always match payment dates and this inefficiency can increase the portfolio cost.
- For instance, at 6.00% rates, the balloon security maturing a month prior to the due date could increase the portfolio cost over $200k. This is also why your defeasance advisor should work with more than one broker dealer (we do). If another broker dealer has access to a bond that matures closer to the payment due date, the portfolio cost could be lower. However, it’s possible there’s simply no better security and the lowest cost has already been obtained.
Rate Buydowns
Buying down the rate also helps in a big way when it comes to future prepayment penalties. The lower the starting point (Note Rate), the lower the potential penalty. Let’s continue with our examples assuming the Note Rates are bought down 0.50%. Note, this analysis ignores the reduction to the debt service resulting from a lower Note Rate.
The first table outlines the defeasance penalties. With 3 years remaining, the penalties are almost $700k lower.
Next, we’ve outlined the YM penalties. The reduction is similar but the 1% minimum penalty kicks in sooner.
The final tables outline the changes to the penalty in both dollars and percent of loan balance.
First, defeasance.
Next, yield maintenance.
Takeaway
With 3 years remaining and 3.00% rates, when we put it all together electing YM and buying the rate down 0.50% reduces the penalty a combined 2.63% of the loan balance (or ~$1.32mm). The tradeoff being, if replacement rates are at or near the Note Rate in the future, the 1% penalty may negate the benefits.
If you’re fixing debt today but are concerned about the future potential prepayment penalty, it’s worth considering the various options lenders offer and quantifying how they may impact you in the future. If you’d like our help evaluating those options, give us a shout.
Pensford has been a trusted partner of real estate investors for over 15 years. Our deep industry expertise and transparency enables our clients to make informed decisions, helping to protect their investments from market volatility and ensure stability.
