How to Diffuse a Prepayment Penalty

  • With the federal reserve raising interest rates, property owners may look to alternative methods of financing.
  • If these methods have early prepayment penalties, one way to avoid those is to defease the loan when selling the underlying property.
  • By tying an investment payout to the loan payments, a property owner can sell a property and avoid a prepayment penalty.

When real estate folks get together in a group, there are a limited number of topics we all talk about. Especially if there are things going on in the country that greatly impact the real estate world.

That’s a long way of saying that lately all anyone wants to talk about is rising interest rates. And I reckon I will specifically write about that soon. But the fed has raised rates this year and will continue to do so.

As interest rates increase, investors and developers are looking to alternate types of financing. Indeed, I was just having a conversation with my good friend Matt Counts about the life insurance lenders that he works with and all the options he provides his clients. And these and other lending vehicles can be great. But the loans often come with prepayment penalties.

So what does an owner do if it wants to sell its property that has a loan with a large prepayment penalty on it? We are going to talk about one of the options this week.

Options for Dealing with a Prepayment Penalty


Maybe the most common, easiest way to deal with a loan with a large prepayment penalty is to just have the new buyer assume the loan. And with a rising interest rate market like we are in, this may not be a bad option. The loan may well have better terms than the buyer could get in the market.

But there is also another option. The seller can defease the current loan.

What is Defeasance?


Defeasance is the process of repaying a commercial real estate loan by switching the payment to something more stable and government-backed, typically a US Treasury Bond. This is usually done to assist in refinancing the real estate or selling it. This switch does not change how much is owed, and the principal and interest must be paid in full to the lender.

Essentially with the proceeds from the real estate sale, the Seller buys a security that will pay out the exact same amount, at the same time, as the current note on the property. Thus each month, the security issues a coupon that makes the payment on the outstanding loan.

How does Defeasance Work?


As described above, defeasance is a prepayment plan for an outstanding loan. The Seller invests in a security through a special defeasance company. And then the defeasance company makes sure the security pays out directly to the loanholder.

As we talked about above, one of the main benefits for borrowers is to circumvent the prepayment penalties of the underlying loan. Defeasance does this through “the purchase of Treasury bonds with maturities equal to the remaining term of the loan, with coupon rates that provide the necessary income to offset the contracted periodic interest and principal payments”. The potential downside is this could leave the owner vulnerable to interest rate rise. The owner may have to pay more for the defeasement security if rates are higher than they were when the original loan was purchased.

Obviously a Seller has to pay for the defeasance security. That reduces the amount of the sale proceeds going to it. But that defeasement fee for the security can be much lower than a prepayment penalty. Thus defeassnce can be a great way to avoid large prepayment penalties. And, as a result, make unique loan structures more attractive when initially purchasing a property.

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