Unlike residential loans which rarely penalize early payoffs, commercial real estate loans commonly incorporate structured prepayment penalties designed to preserve yield for bond investors, life insurance companies, and portfolio balance sheets.
Key Financing Parameters & Standards
Institutional Market Reference
Step-Down StructureDeclining Percentage (e.g., 5-4-3-2-1% of outstanding balance)
Yield MaintenanceMake-whole formula discounting interest rate spread against U.S. Treasuries
DefeasanceSubstitutes mortgage collateral with U.S. Treasury bond portfolio
Lockout WindowsPeriod during which loan cannot be paid off under any condition
Open WindowTypically 30 to 90 days prior to maturity with 0% prepayment penalty
* Floating-rate bridge facilities typically offer short 6-to-12-month prepayment lockouts followed by open exit terms.
In institutional commercial real estate, lenders fund loans by issuing commercial mortgage-backed securities (CMBS) to bondholders or by matching long-term liabilities on insurance company balance sheets. If a borrower pays off a 10-year, 6.5% mortgage in year two because market interest rates dropped, the lender suffers reinvestment risk.
To guarantee expected financial returns, commercial debt contracts establish structured prepayment mechanisms. Borrowers must understand these structures before closing to avoid multimillion-dollar exit fee surprises.
The Three Primary Commercial Prepayment Structures
Commercial lenders utilize three primary prepayment methodologies depending on loan duration and capital source:
Common in portfolio bank loans and balance-sheet bridge debt. The penalty is expressed as a simple percentage that steps down each year the loan remains outstanding (for example, a 5-4-3-2-1 structure charges 5% in year one, 4% in year two, down to 1% in year five).
Predictable dollar cost regardless of whether interest rates rise or fall
Ideal for sponsors planning a property sale or refinance within 3 to 5 years
2. Yield Maintenance (Make-Whole Math)
Common in life insurance company loans and agency multifamily debt. If prevailing interest rates drop, the borrower must pay the present value of the interest spread the lender would lose by reinvesting the repaid principal into current U.S. Treasuries.
Can be extremely expensive in falling interest rate environments
Includes a minimum floor penalty (typically 1.0% of loan balance)
3. Defeasance (Bond Portfolio Substitution)
The standard prepayment mechanism in CMBS conduit loans. The borrower does not actually pay off the loan; instead, the borrower purchases a portfolio of U.S. Treasury securities that replicate the exact remaining principal and interest payments, releasing the real estate mortgage lien.
Allows property to be sold or refinanced free and clear of the original mortgage
Requires engaging a defeasance consultant, securities intermediary, and legal counsel
Prepayment Lockout Periods & Open Payoff Windows
Many fixed-rate institutional facilities feature an initial "lockout" period (typically 1 to 3 years) during which the loan cannot be prepaid under any circumstances. Conversely, virtually all commercial loans feature an "open window" (typically the final 30, 60, or 90 days before maturity) where the loan can be satisfied at par with zero penalty.
Frequently Answered Questions
Common Questions About Commercial Prepayment Penalties: Yield Maintenance, Defeasance, & Step-Down
Direct, transparent answers regarding underwriting standards, documentation, and process.
Penalty Cost
Which commercial prepayment penalty is least expensive when interest rates fall?
Direct Answer
A declining step-down schedule is generally the least expensive when interest rates drop, because its cost is capped at a fixed percentage rather than compensating for lost interest yield.
Yield maintenance and defeasance become substantially more expensive when benchmark Treasury yields decline below the note rate.
Defeasance vs Payoff
What is the main difference between defeasance and yield maintenance?
Direct Answer
In yield maintenance, the loan is formally extinguished by paying a cash penalty to the lender. In defeasance, the loan remains active, but the real estate collateral is replaced with a portfolio of government bonds.
Defeasance is required on securitized CMBS loans because the underlying trust must continue receiving payments to distribute to bond investors.
Connect with our commercial underwriting team. We provide prompt indicative pricing, leverage sizing, and lender placement strategy upon scenario review.
