The main advantages of defeasance for commercial real estate financing are that it removes any risk of repayment for the lender, and can be advantageous for a note with a variable rate. It can also have accounting benefits, as it replaces the collateral with securities and removes the debt from a company’s balance sheet.

The main disadvantages of defeasance come down to cost. The process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully, and this time factor can make the process itself prohibitively expensive. Additionally, the costs are increased by the intensive capital investment into the replacement collateral — the bonds — used to offset the yields.

The main advantage of yield maintenance for commercial real estate financing is the lower capital requirements compared to defeasance. Yield maintenance can be handled with a simple (although not insignificant) payment as a one-time penalty, leaving capital available for other uses, such as renovating a property. Another advantage is its simplicity compared to defeasance.

The biggest downside of yield maintenance occurs if this option is exercised in an environment where interest rates are falling. If a borrower plans to refinance at a lower interest rate, for example, the cost of yield maintenance may be greater than just continuing to make payments on the existing loan. As a result, the penalty could be far more expensive than if a loan had any one of a number of other prepayment penalties.

The tax implications of defeasance for commercial real estate financing depend on the specific situation and wider economic conditions and trends. Generally, defeasance can be advantageous for borrowers if interest rates are expected to rise. By replacing the loan’s collateral with bonds, a borrower doesn’t need to be concerned with rising rates. Additionally, defeasance can have accounting benefits, as the debt is effectively removed from a company’s balance sheet.

For more information, please refer to the IRS website and this blog post.

The tax implications of yield maintenance for commercial real estate financing depend on the type of loan and the borrower's tax situation. Generally, the borrower will be able to deduct the yield maintenance penalty as an ordinary business expense. However, if the loan is a non-recourse loan, the borrower may be subject to the alternative minimum tax (AMT) on the penalty. It is important to consult with a tax professional to determine the exact tax implications of yield maintenance for your particular situation.

Sources:

• Defeasance or Yield Maintenance: Which Is Better?

The main disadvantages of defeasance come down to cost. The truth is that defeasance can be extremely expensive. First, the process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully. As these aren’t single-day transactions — and can take months, depending on the situation — this time factor can make the process itself prohibitively expensive. Second, beyond the staff requirements, defeasance’s costs are also increased by the intensive capital investment into the replacement collateral — the bonds — used to offset the yields.

Just like a commercial or multifamily real estate investor involved in litigation would generally rather hire a lawyer than representing themselves in court, most borrowers who want to defease their loan will generally hire a defeasance consultant to conduct the entire process for them. While the concept may sound simple, defeasance, overall, can be somewhat complex. The exact amount of bonds must be purchased, secured in the proper way (typically a custodial account), and recorded and filed property for tax purposes. In addition, a certain amount of negotiation and communication with the lender will typically be required throughout the entire process. For instance, while defeasance is tax-deductible, a borrower (or their original accountant) may not be used to filing the type of paperwork and documentation required for a borrower to take the deduction.

The costs associated with defeasance for commercial real estate financing include the cost of hiring a team of experienced accountants and legal experts, the cost of the intensive capital investment into the replacement collateral, and the cost of hiring a defeasance consultant to conduct the entire process. In addition, there may be additional costs associated with filing the necessary paperwork and documentation for a borrower to take the deduction.

The cost of yield maintenance is the difference between the interest rate of the existing loan and the interest rate of the new loan, multiplied by the remaining principal balance of the existing loan. This cost is typically paid in a lump sum at the time of refinancing.

The biggest downside of yield maintenance occurs if this option is exercised in an environment where interest rates are falling. If a borrower plans to refinance at a lower interest rate, for example, the cost of yield maintenance may be greater than just continuing to make payments on the existing loan. As a result, the penalty could be far more expensive than if a loan had any one of a number of other prepayment penalties.

For more information, please visit Yield Maintenance Calculator and Defeasance or Yield Maintenance: Which Is Better?.