In many ways, defeasance is similar to yield maintenance, except instead of a complete payoff, the collateral for the loan is swapped from the real estate to securities bearing the same cash-flow stream. As with yield maintenance, as interest rates rise and time passes, the resulting penalty will decrease. Unlike yield maintenance, it’s possible in a rising interest-rate environment for defeasance to become an asset to the borrower. If current rates are significantly higher than the rate on the loan, the result may be a payoff amount below the outstanding loan balance.
There will be additional costs to defeasance, as it takes a specialist to ensure the calculations are done correctly. There are a number of online tools that estimate the cost of yield maintenance and defeasance, such as this one: www.thebscgroup.com/commercial-real-estate-defeasance-calculator.html.
Should I Refinance?
Now that you've calculated the cost of prepayment, the more complicated question is whether this is the right time to refinance. The simplest way to decide this is to first compare the cost of the prepayment penalty, plus any transaction costs for the new loan, with the interest savings from the reduced interest rate for the remaining term of the loan. If the savings is positive, you could conclude this is a good time to refinance. Additionally, the new lender will likely allow the prepayment penalty to be rolled into the new loan to lessen the upfront costs.
However, a strong argument can be made for refinance even if there isn’t any immediate interest savings. Managing future interest-rate risk during your investment horizon might be an even more powerful reason. With interest rates at historic lows and a slowly improving economy, it seems inevitable that rates will begin to rise in the near future. Managing your future risk by locking in a long-term rate now rather than rolling the dice at loan maturity in a few years is likely worth the cost of prepayment. Even if you’re thinking about selling your property, many long-term loans offer assumption features that would be an asset to any buyer should interest rates be higher at the time of sale.
Now is the time to refinance, and every borrower can do his own analysis fairly easily. If you have a prepayment penalty, examine your loan documents to understand your options with your current lender. Next, calculate your penalty and compare it to your potential savings on a new loan. Finally, look at your investment horizon and understand the potential for rising interest rates. The small cost of refinance now may be pennies compared to increased rates in the future.
Noel Cain is a vice president and Casey McGrath is an associate vice president at Chicago-based The BSC Group , a commercial real estate financing advisor and provider of debt and equity capital solutions for self-storage owners nationwide. Cain provides mortgage brokerage, financial consulting and loan-workout solutions. Reach him at 847.778.4661 or firstname.lastname@example.org . McGrath provides analytical support and mortgage brokerage solutions for a diverse set of clients. Reach him at 312.878.7561 or email@example.com .