Fixed-rate commercial real estate loans are priced on the assumption that the lender will receive contractual interest payments for the full loan term. When a borrower prepays early, the lender receives the principal but loses the interest stream and faces reinvestment risk — finding an equivalent return may be impossible if market rates have fallen since origination. Defeasance and yield maintenance are the two primary mechanisms lenders use to protect against this harm. Both appear as standard provisions in CMBS loans and many institutional commercial mortgages, and understanding them is essential for any borrower contemplating a sale or refinancing before maturity.
Yield maintenance compensates the lender for lost yield. The borrower pays a make-whole premium equal to the present value of the difference between the contractual interest rate and the reinvestment rate — typically the Treasury rate for the period matching the remaining loan term — discounted at the same Treasury rate. If the borrower carries a 6.5% loan with three years remaining and the three-year Treasury is at 4.5%, yield maintenance compensates the lender for the 200 basis point differential over the remaining term, discounted to present value. Most yield maintenance provisions include a floor — commonly 1% of the outstanding principal balance — so the borrower always pays at least a minimum penalty even in a rising rate environment where the contractual rate is below market and the standard formula would produce zero or negative premium.
Defeasance does not prepay the loan — it replaces the real estate collateral with a portfolio of US government securities structured to produce cash flows that exactly match the remaining scheduled loan payments. The borrower purchases a Treasury bond or agency securities portfolio, pledges it to the lender as substitute collateral, and receives a release of the mortgage lien on the property. The lender continues to receive exactly the cash flows it was contractually promised, now from default-free government securities rather than real estate income. The property is released from the lien and can be sold or refinanced without triggering any further obligation under the original loan. The cost of defeasance is the market price of the qualifying securities portfolio minus the outstanding loan balance — in a low-rate environment, this can be very expensive because Treasury bonds yield less than the loan's contractual rate and must therefore be purchased at a premium.
CMBS loans almost universally require defeasance rather than yield maintenance because the structural requirements of a CMBS trust — with its pass-through certificate mechanics and strict payment waterfall — make yield maintenance payments legally and operationally complex to handle within the trust structure. Life company loans and some bank loans use yield maintenance. Borrowers considering a sale or refinancing need to calculate the applicable prepayment cost early in the underwriting process, because this cost can be material enough to determine whether a transaction makes economic sense, affect the net proceeds to the seller, or determine which bid wins in a competitive property sale. Most loans have an open prepayment window — typically the final three to six months before maturity — during which the borrower can repay without penalty, and many borrowers time dispositions to align with this window to eliminate the prepayment cost entirely.
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