Commercial real estate investors may pay prepayment penalties when favoring fixed-rate debt financing. The prepayment penalties appear when setting their debt ahead of their loans’ maturity dates. Idaho law has buyers and sellers execute and deliver all documents and necessary funds to the closing agent. Defeasance is a prepayment option that offers potential financial gains when interest rates rise.
Benefits of defeasance
Defeasance is a way for borrowers to reduce the fees when repaying a fixed-rate commercial real estate loan. Under commercial real estate law, borrowers can exchange the collateral on their loan with another cash flow-yielding asset. The new collateral is usually less risky for the lender but offers the same cash flow. If someone’s loan interest rates rise higher than their mortgage, they can benefit. Borrowers can consider defeasance during commercial real estate loan negotiations.
Risks for lenders
Fixed-rate financing may create financial losses for lenders when the borrower repays the capital at lower market rates. The repayment penalties for borrowers help balance the reinvestment risk for lenders. The original loan uses yield maintenance to dictate the pay-rate differential. Defeasance can end reinvestment risk and the need for re-lending prepaid capital. Replacing the collateral of the commercial real estate loan is a less risky option.
Rationale for defeasance
Variable-rate commercial real estate loans are for short-term projects such as bridge financing or construction. Capital loaned to real estate owners in the lease-up phase is repaid when the property yields cash flow. There’s a high risk to the interest rate for borrowers that use property that could sell before the loan matures. Borrowers use variable financing to circumvent prepayment penalties on fixed-rate debt. Lenders don’t suffer reinvestment risk with variable-rate financing.
Variable-rate financing allows the loan rates to move with the market, and the funds can stay at the same market rates. Fixed-rate financing has the risk of financial loss by lending at a lower fixed rate than the current market. There are risks and benefits for defeasance with commercial real estate loans for borrowers and lenders. Types of commercial real estate loans are situational, but understanding the effects of defeasance brings you closer to a decision.