Yield maintenance and defeasance are 2 ways a fixed-rate commercial real estate loan protects the lender's expected return when a borrower repays early. Yield maintenance charges a premium equal to the interest the lender loses by reinvesting at a lower Treasury rate. Defeasance replaces the loan's collateral with Treasury securities that keep making the scheduled payments. Both usually cost more when rates have fallen since the loan closed and less when rates have risen.
Why commercial loans restrict prepayment
A lender or investor that funds a fixed-rate loan expects a stream of payments at that rate for the full term. If the borrower repays early and market rates have fallen, the lender has to reinvest the money at a lower return. Prepayment terms shift that risk back to the borrower. They matter most when a borrower plans to sell or refinance before maturity, which is why they deserve as much attention as the rate itself.
How yield maintenance works
Yield maintenance charges a premium that makes the lender whole for the interest it would have earned. The premium is generally the present value of the difference between the loan's interest rate and a comparable Treasury yield, applied to the outstanding balance over the remaining term, usually with a minimum such as 1% of the balance.
A simplified, hypothetical example shows the mechanics. Assume a $10,000,000 balance at a 6.00% loan rate with 5 years left, and a matching Treasury yield of 4.00%. The lender loses about 2.00% a year on $10,000,000, or roughly $200,000 a year for 5 years. Discounting those payments back to today produces the premium, which in this example lands a little under $900,000. If the Treasury yield had risen to 6.00% or higher, the premium would fall to the contractual minimum.
Yield maintenance is common on life insurance company loans, agency multifamily loans, and many balance-sheet fixed-rate loans.
How defeasance works
Defeasance does not repay the loan. The borrower buys a portfolio of government securities that produces cash flows matching every remaining payment, including the balance at maturity or the open prepayment date. That portfolio replaces the property as the loan's collateral, the property is released, and a successor entity assumes the loan and makes the payments from the securities.
The cost is the price of the securities portfolio minus the loan balance, plus third-party costs for the consultant, accountants, legal work, the successor borrower, and servicer fees. When Treasury yields are below the loan rate, the securities cost more than the balance and defeasance is expensive. When yields are above the loan rate, the portfolio can cost less than the balance.
Defeasance is standard on CMBS loans, where the loan sits in a securitization and the bond investors expect the cash flows to continue.
Comparing the 2
| Yield maintenance | Defeasance | |
|---|---|---|
| What happens to the loan | Repaid with a premium | Stays outstanding, secured by Treasury securities |
| Typical lenders | Life companies, agency, balance-sheet lenders | CMBS lenders |
| Cost driver | Loan rate versus Treasury yield, remaining term | Loan rate versus Treasury yields, remaining payments |
| Transaction work | Payoff letter | Securities purchase, successor borrower, legal and servicer approvals |
| Can the cost fall below zero? | Usually floored at a minimum premium | Portfolio cost can fall below the balance when rates rise |
Other prepayment structures
Step-down prepayment charges a fixed percentage that declines each year, such as 5%, 4%, 3%, 2%, and 1% over 5 years. It is common on bank and bridge loans and is easy to budget. Open periods allow prepayment without a premium near maturity, often the last few months of the term. Lockouts prohibit prepayment for a set period, common in the early years of CMBS loans. Floating-rate loans often carry minimal prepayment cost after a short minimum-interest period.
Negotiating prepayment before you sign
Prepayment is negotiable at the term sheet stage and very hard to change afterward. Borrowers can ask for a shorter term that matches the business plan, a longer open period, a step-down instead of yield maintenance, the right to assume the loan on a sale, or partial release provisions for multi-property loans. The right answer depends on how likely a sale or refinance is before maturity.
The best time to model an exit is before the loan closes. Capital Partners compares prepayment terms across lenders alongside proceeds, rate, and recourse so the loan fits the hold period. Submit a deal to review the options for your property.