Defeasance vs Yield Maintenance: A Prepayment Penalty Walkthrough

TL;DR

Defeasance and yield maintenance are the two dominant prepayment penalty structures on long-term fixed-rate commercial mortgages — particularly CMBS loans (typically defeasance) and life insurance company loans (typically yield maintenance). Both protect the lender from losing the yield they expected to earn over the loan's remaining term. Both can cost real money on early payoff when current Treasury yields are lower than the loan's original coupon. But they work mechanically very differently: defeasance substitutes U.S. Treasury securities as collateral and redirects cash flows, while yield maintenance is a cash fee calculated as the present value of the interest the lender would have earned. This post walks through each mechanism, when each is cheaper, and what to ask before accepting either.

Why Prepayment Penalties Exist

When a lender originates a 10-year fixed-rate commercial mortgage, they've committed to receiving a specific coupon for 10 years. If interest rates fall meaningfully during the loan term, that above-market coupon becomes valuable — the lender is collecting rent on money more cheaply borrowed elsewhere.

If the borrower could prepay the loan at any time without penalty, they'd simply refinance into a lower-rate loan whenever rates dropped, leaving the original lender with capital to redeploy at the new (lower) market rate. The lender would lose the spread.

Prepayment penalties address this asymmetry. They come in three main flavors:

• Defeasance — CMBS standard; converts the loan to a Treasury-backed equivalent
• Yield Maintenance — life insurance company standard; cash payment of lost yield
• Stepdown / lockout — fixed schedule prepayment fees; bank and debt fund standard

This post focuses on the first two — defeasance and yield maintenance — because they're the most common (and most expensive) on net lease financing.

Defeasance: The Treasury Substitution

Defeasance is the prepayment structure used on nearly all securitized (CMBS) loans, and occasionally on life insurance company loans as well. The mechanic:

1. Borrower assembles a portfolio of U.S. Treasury securities that exactly replicates the remaining cash flows of the loan — all future principal and interest payments through maturity.

2. The Treasury portfolio is substituted for the property as the collateral securing the loan. The loan isn't paid off; it's recast to be backed by government securities instead of the commercial real estate.

3. The loan continues to be serviced with the Treasury cash flows flowing through to bondholders. The property is released from the loan collateral, free to be sold or refinanced.

The borrower's out-of-pocket cost is the price of the Treasury portfolio — which depends on the market relationship between current Treasury yields and the loan's coupon.

The Core Economics

The defeasance cost at any point in time:

Defeasance Cost = Present Value of remaining loan payments, discounted at current Treasury yields

If current Treasury yields equal the loan coupon at the time of defeasance, the cost is approximately the current principal balance — a small premium for execution costs and any yield mismatch.

If current Treasury yields are below the loan coupon (the typical scenario that triggers defeasance), the cost is higher than the loan balance. The difference represents the value of the above-market coupon over the remaining term.

If current Treasury yields are above the loan coupon (rare but possible), the cost is lower than the loan balance — the borrower can purchase Treasuries at a discount to what they need to replicate the loan cash flows. In theory, this could even produce a net gain, though execution costs usually eat into any such benefit.

Execution Costs

Defeasance is administratively complex. Typical third-party costs (paid by the borrower):

• Defeasance consultant: manages the execution process; fees typically $15K-$40K+
• Successor borrower counsel: required because the loan is being transferred to a single-purpose defeasance entity; fees typically $15K-$25K
• Accountant verification: confirms the Treasury portfolio cash flows match the loan cash flows; fees typically $10K-$15K
• Trustee and servicer fees: CMBS trust charges for processing the defeasance; fees typically $10K-$20K
• Total execution costs: usually $50K-$100K+ on top of the Treasury portfolio cost

Execution typically takes 30-60 days from the borrower's decision to the closing of the defeasance. The loan must be defeasable (not in the lock-out period, typically the first 2-3 years of the loan term) and various other conditions must be met.

When Defeasance Matters Most

Defeasance cost scales with the spread between current Treasury yields and the original loan coupon. In a falling-rate environment, defeasance costs can become substantial:

• If rates fall 50 bps, typical defeasance cost is a few percent of the loan balance plus execution costs
• If rates fall 150 bps, defeasance cost can easily reach 10-15% of the loan balance
• If rates fall 300+ bps (as happened during 2020 COVID-era rate moves), defeasance costs on loans originated at higher coupons could exceed 25% of the balance

For net lease investors planning short holds, defeasance is often the largest single friction in early sale or refinance.

Yield Maintenance: The Cash Payment

Yield maintenance serves the same economic purpose as defeasance — compensate the lender for lost yield — but through a direct cash payment rather than a securities substitution.

The mechanic:

1. At the time of payoff, the lender calculates the present value of the interest payments they would have received had the loan stayed outstanding to maturity.

2. The discount rate is typically the current matching-duration Treasury yield (plus sometimes a small add-on, depending on the specific loan's YM formula).

3. The borrower pays off the loan principal PLUS this yield maintenance amount.

The Core Economics

Yield maintenance premium at any point in time:

YM Premium = PV of (Loan Coupon − Treasury Yield) × Principal Balance, over remaining term

This is mathematically similar to defeasance — both calculate the PV of "lost yield" between the loan coupon and the current Treasury reinvestment rate.

When current Treasury yields are below the loan coupon, YM premium is positive (borrower pays).

When current Treasury yields are equal to the loan coupon, YM premium is approximately zero.

When current Treasury yields are above the loan coupon, YM premium is typically zero (floored at zero; borrowers don't get paid) — unlike defeasance, YM usually has an asymmetric protection.

Execution Costs

Yield maintenance is much simpler to execute than defeasance:

• Lender calculation: the lender computes the YM premium per the formula in the loan documents. No consultant required.
• Legal review: typically the borrower has counsel verify the calculation; fees usually under $10K
• Timing: 2-4 weeks from decision to payoff

Total execution costs typically under $15K — a fraction of defeasance execution costs.

YM Formula Variations

Different loans have different YM formulas. Some common variations:

Standard YM: discount at current matching-duration Treasury yield

Treasury + X: discount at Treasury yield + X basis points (often 25-50 bps)

Floor variant: minimum prepayment fee regardless of rate environment (often 1-3%)

"Make-whole" variant: effectively YM but phrased as a full make-whole payment

Read the loan documents to understand the specific YM formula. Two loans with "YM prepayment" can have materially different prepayment economics depending on the exact formula.

Side-by-Side

Cost Example: Identical Loan, Identical Rate Environment

Consider a $5M loan at 5.5% coupon with 6 years remaining, and current 6-year Treasury yields at 4.0%. Approximate costs under each structure (illustrative — actual numbers depend on specific loan terms):

Defeasance:

• Treasury portfolio replicating remaining 5.5% cash flows at 4.0% discount rate: approximately $5.4M
• Execution costs: approximately $75K
• Total: approximately $5.475M, or ~9.5% premium over principal balance

Yield Maintenance (standard form):

• PV of 150 bps spread × $5M × 6-year duration (simplified): approximately $400K premium
• Execution costs: approximately $10K
• Total: approximately $5.41M, or ~8.2% premium over principal balance

In this example, YM is cheaper than defeasance by approximately $65K — mostly the execution cost differential. In a sharply falling-rate environment, that differential can grow further.

When Each Is Cheaper

Defeasance tends to be cheaper than YM when:

• Treasury yield is close to or slightly above the loan coupon (defeasance protections can produce small wins; YM floors at zero)
• The specific YM formula has a floor or additional spread (effectively making it "defeasance plus")

YM tends to be cheaper than defeasance when:

• Rate environment has meaningfully lower Treasury yields than the original coupon (standard case)
• Borrower values the simpler, faster execution

What to Ask Before Signing

Before agreeing to a CMBS or life co loan with a long prepayment penalty:

1. What's my actual prepayment structure? Defeasance, yield maintenance, or stepdown? Read the loan documents.

2. What's the lockout period? Many loans don't allow prepayment at all in years 1-2 (or longer). During lockout, neither defeasance nor YM works — you simply can't prepay.

3. Is there an "open" period at the end? Many loans have an open prepayment window in the final 3-6 months before maturity, allowing free prepayment in that window.

4. What's the YM formula specifically? Standard Treasury-based, Treasury-plus-spread, or make-whole? This can change the cost materially.

5. What are my realistic hold period scenarios? If you might sell in 3-5 years, prepayment penalty is a meaningful economic consideration. If you intend to hold through maturity, it barely matters.

6. Is there an assumption alternative? Selling the property with the loan assumed is one way to avoid prepayment penalty. Both CMBS and some life co loans allow assumption with lender approval and fees. Budget for assumption fees typically 1% of loan balance, plus legal/servicer costs.

The Bottom Line

Defeasance and yield maintenance are two answers to the same question — how does the lender protect their expected yield? Both work. The cost differential is mostly in execution (defeasance is much more expensive to execute), with the PV-of-yield economics being similar in equivalent rate environments.

For a net lease buyer planning to hold to maturity, the choice between defeasance and YM barely matters. For a buyer planning to sell before maturity, the choice matters significantly. The best time to think about prepayment penalty is before signing the loan — not when you're trying to close a sale 5 years later.

Editorial disclaimer. This article is published by Trestle Research for informational purposes only. It is not legal, tax, or investment advice. Loan document terms vary by transaction; specific prepayment provisions should be verified directly in the loan agreements for any specific loan. Illustrative calculations above are simplified for clarity. Always consult qualified counsel and your loan servicer for specific calculations.

Run your net lease deal through Trestle. We underwrite for hold-period flexibility and financing structure so you understand your prepayment exposure before signing a term sheet. First deal is free. [Start underwriting →](/sign-up/broker)