Why you cannot prepay a securitized loan

Borrowers assume they can always pay a loan off early, maybe with a penalty. On much of commercial real estate debt, that assumption is wrong. A securitized loan often cannot be prepaid at all for most of its life, and when the borrower does need out, to sell or refinance, the way out is not a check to the lender. It is buying a portfolio of government bonds to stand in for the loan. The rule that forces this is not the lender being difficult. It is federal tax law governing the trust that holds the loan.

On a securitized loan, prepayment is usually prohibited. Exiting early means a make-whole payment or substituting a bond portfolio for your building, and the terms are set at origination, not negotiated at exit.

Paying early is a privilege the loan may not grant

Prepayment terms decide whether, when, and at what cost a borrower can retire a loan before maturity. On simple bank loans they are mild, often a step-down penalty that declines each year, 5 percent in year one, 4 in year two, down to zero. On securitized loans, the ones packaged and sold to bond investors, the terms are far stricter, because the borrower’s loan is now backing somebody’s bond and that bondholder expects a predictable stream of payments.

Those loans typically start with a lockout, a period, often around the first two years, during which prepayment is simply not allowed at any price. After the lockout, the borrower can exit, but only through one of two regimented processes, and only near the end of the term does a short open window appear where the loan can be prepaid at par with no penalty.

Yield maintenance: pay the loan plus the lender’s lost interest

Yield maintenance is the simpler of the two. The borrower repays the outstanding principal plus a penalty equal to the present value of the interest the lender will not now collect. The penalty makes the lender whole for the yield it expected, and it is commonly at least 1 percent of the balance and can run to 3 percent or more depending on how far rates have moved. Yield maintenance is a payoff: the loan is gone, the lender is compensated for the early exit.

Defeasance: you do not pay it off, you replace the collateral

Defeasance is stranger, and it is the norm on CMBS loans. The borrower does not pay the loan off. Instead the borrower buys a portfolio of government securities, Treasuries or sometimes agency bonds where the documents allow, structured so their payments exactly reproduce the loan’s remaining payment stream. Those securities are substituted for the real estate as the loan’s collateral. The building is released, free to be sold or refinanced, and the loan itself continues to live inside the bond trust, now paid by the bonds instead of the borrower. It is a collateral swap, not a payoff, and it usually requires a specialist, a small team of lawyers and accountants, and about a month to execute.

Why the rule exists: REMIC, not the lender

The reason for all of this is a tax structure called a REMIC, the real estate mortgage investment conduit that holds securitized loans and issues the bonds. REMIC rules sharply limit what the trust can do with its loans, and they are what forbid ordinary prepayment. Without a lockout, bond investors would carry the loans’ interest-rate risk: borrowers would refinance and pay off whenever rates fell, and sit tight whenever rates rose, handing the trust exactly the loans it did not want. Defeasance is the workaround the rules permit, letting the borrower out while keeping the trust’s payment stream intact. The prohibition is structural. No amount of goodwill from the loan servicer changes it, because the servicer cannot violate the REMIC rules either.

The cost swings with rates, sometimes in your favor

Defeasance cost depends on what Treasury yields are doing relative to the loan’s rate, and the direction surprises people. When rates have fallen below the loan’s rate, the replacement bonds are expensive, because low-yielding bonds cost more to produce the same payment stream, so defeasance is costly. When rates have risen above the loan’s rate, the replacement bonds are cheap, and defeasance can cost little or even return cash to the borrower, who buys the required payment stream for less than the loan balance. The same exit is a heavy penalty in one rate environment and a windfall in another, on the identical loan.

The consequence: the exit is priced at entry

Prepayment is the term that decides whether a borrower can act on a decision to sell, refinance, or hold at all, and it is fixed at origination, usually non-negotiable on CMBS. A deal that may need to sell or refinance mid-term should never take a long-lockout, full-defeasance loan without pricing that exit into the plan, because the prepayment regime can make a mid-term exit either impossible or ruinously expensive regardless of how well the property performs. Read the prepayment section before signing, map the lockout, the yield-maintenance-or-defeasance window, and the open period against the deal’s likely hold, and know that on a securitized loan the cheapest exit is often simply waiting for the open window, which is a plan only if the business plan can wait.