During the last cycle, commercial mortgage back securities lending gained in popularity culminating in a frantic pace of origination between 2005 and 2008. During that period, many loans were defeased, but for a fairly long stretch of time following the implosion of the CMBS market, the economics of defeasance rarely made sense. However, with rates still near historic lows and sales prices favorable to sellers, many more loans will be defeased over the next several years. But what should you know if you are considering defeasing a loan, and what should you know if you are getting into a new loan with defeasance “prepayment” provisions?
What is Defeasance?
Defeasance is an alternative to traditional prepayment penalties such as yield maintenance and fixed percentage penalties. Defeasance, rather than being a true prepayment, represents the substitution of securities collateral for real estate collateral, which in turn allows a release of the lien on the property freeing it for refinancing or sale. A borrower’s property is released when a portfolio of U.S. Government securities is used to replace the cash flow covering the debt service. A special purpose entity, known as the Successor Borrower, is created to assume the role of the borrower and by making payments on the loan using the portfolio of securities. The complexity and upfront costs of defeasing a loan can be intimidating, and the complexity of the process has often led to an uneven playing field.
Level the Playing Field
If you have not defeased a loan before, or if you were uncertain how you fared in a prior defeasance, get good advice and demand transparency. If you have a loan that may require defeasance any time over the next three years, a qualified intermediary can help. For instance, Colliers Boston partners with select defeasance providers who will review existing loan documents, issue quotes specifically tailored to the loan provisions and periodically update the costs until the time for defeasance is right. This has several advantages over relying on an online defeasance calculator; notably, reliability that can only be established by review of replacement collateral requirements and duration of defeasance period. For instance, certain CMBS loans provide a choice between defeasance and yield maintenance, or allow borrowers to substitute higher yielding replacement securities than treasury instruments. In short, take the opportunity to confirm what your true prepayment situation is.
When it comes time to defease, transparency becomes even more important. Are the replacement securities optimized for the borrower? Are the transaction costs fair? Is the borrower the beneficiary of the value of the successor borrower? Think about this. Most loans have a 30-180 day open prepayment window, but most older loan documents require the borrower to buy replacement securities through loan maturity. If the successor borrower later repays the loan at the beginning of the open prepayment window, they will reap a windfall. Will you participate in that when it happens or be offered a present value share of that value at the time of defeasance?
To simplify thinking about defeasance, one needs to realize that two variables – the reduction of remaining loan term and increased replacement securities yields - cause the cost to decrease. One of the fundamental benefits of defeasing your loan is the flexibility to refinance your property at current low rates. Like yield maintenance, the present value of remaining interest payments generally represent the largest component of defeasance cost. The most obvious risks in deferring a refinance until the open period are refinancing into a higher rate and maturity risk from refinancing in a less liquid future capital markets. Therefore, once defeasance is modeled, you can monitor rates, capital market conditions and defeasance costs to react at an optimal point in time. For many borrowers, that happens at a point in time 12 to 18 months prior to loan maturity. Also, keep in mind that the prepaid interest component of defeasance may be tax deductible, something you should discuss with your tax professional as a part of your overall portfolio strategy. Ultimately, deferring a refinance, or missing an opportunity to forward rate lock, in a rising rate environment means you could lose out by waiting until 2017 or 2018 to refinance.
Tom Welch is a senior vice president and a shareholder and John Poole is an associate with Colliers International, Boston.
