If all pulled in one direction, the world would keel over. ~Yiddish proverb
By Thomas Welch, John Poole | Jul.Aug.16
During the last cycle, commercial mortgage backed securities lending gained in popularity, culminating in a frantic pace of origination between 2005 and 2008. During that period, many borrowers went through loan defeasance. But for a fairly long stretch of time following the CMBS market implosion, the economics of defeasance rarely made sense. However, with rates still near historic lows and commercial real estate prices favorable to sellers, many more loans will enter into defeasance over the next several years. This article discusses what borrowers should know if they are considering defeasance, and why they should ask for defeasance prepayment provisions in a new loan.
What Is Defeasance?
Defeasance is the standard CMBS industry alternative to traditional prepayment penalties such as the yield maintenance penalty common to life insurance company loans and fixed percentage penalties common to local bank loans. Rather than being a true prepayment, defeasance is the substitution of securities collateral for real estate collateral. This allows a release of the property lien, freeing the asset for refinancing or sale. A borrower’s property is released when a portfolio of U.S. government securities is structured to replace the cash flow covering the debt service. A special purpose entity, known as the successor borrower, assumes the role of the borrower and makes payments on the loan using the portfolio of securities. The complexity and upfront costs of loan defeasance can be intimidating, and the intricate process has often led to an uneven playing field.
Leveling the Playing Field
Given a choice, most borrowers would prefer yield maintenance or fixed percentage prepayment penalties to defeasance. However, variations to defeasance are uncommon and require spread premiums if elected in a CMBS financing. Yield maintenance, though it requires careful math to estimate accurately, is simple enough to calculate, and fixed percentage penalties are even simpler. Due to the opaque nature of defeasance, defining it up front and calculating when implementing it requires borrowers to seek good advice and demand transparency. Using a qualified intermediary can help.
Using an intermediary has several advantages over relying on an online defeasance calculator. Most notably, it provides reliability through a review of replacement collateral requirements and the defeasance duration period. For example, certain CMBS loans provide a choice between defeasance and yield maintenance, or allow borrowers to substitute replacement securities that offer a higher yield than Treasury instruments. In short, borrowers have the opportunity to confirm what their true prepayment situation is.
When it comes time to initiate defeasance, 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?
Borrowers should think about this. Most loans have a 30- to 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, it will reap a windfall. Will the borrower participate in that windfall when it happens or be offered a present value share of that value at the time of defeasance?
Simply put, understand that two variables – the reduction of the remaining loan term and increased replacement securities yields – decrease the cost of defeasance. One of the fundamental benefits of defeasance is the flexibility to refinance the property at current low rates. Like yield maintenance, the present value of remaining interest payments generally represents the largest component of defeasance cost.
The most obvious risks in deferring a refinance until the open period are the possibility of a higher interest rate and the maturity risk from refinancing in less liquid future capital markets. Therefore, if a qualified intermediary has modeled the loan defeasance, the borrower can monitor rates, capital market conditions, and defeasance costs in real time to better react at an optimal point in time.
For many borrowers, that optimal point in time comes 12 to 18 months prior to loan maturity. Still others employ alternative strategies, such as a forward loan rate lock to reduce or eliminate prepayment costs, or a sale with assumption of the debt as a way to avoid defeasance. Also, the prepaid interest component of defeasance may be tax deductible, something borrowers should discuss with their tax professional as a part of an overall portfolio strategy. Ultimately, deferring a refinance in a rising rate environment means borrowers this year could lose out by waiting until 2017 or 2018 to refinance.
Reducing Defeasance Costs
When financing a property with CMBS debt, borrowers should attempt to negotiate several favorable defeasance provisions. For example, they should define defeasance collateral to include not only U.S. Treasuries but also other agency securities that may have a higher yield. They should seek the right to designate the successor borrower. If possible, they should secure the right to loan defeasance only through the start of an open period as opposed to through maturity. Also they should ask for the rights to deliver securities instead of cash to the lender for their purchase, cap servicer defeasance fees, and choose between defeasance and yield maintenance.
Defeasance can be a powerful tool in today’s low interest rate market. While the defeasance cost will decrease over time to zero, rising interest rates will make new debt more expensive and reduce cash flow after debt service. Using an experienced mortgage broker who works with a qualified defeasance intermediary can help to take advantage of the available refinance opportunities.
Does Defeasance Make Sense?
The decision to use defeasance to refinance depends on several factors, but the financial analysis aspect is relatively straightforward. For example, in 2007, Colliers originated a $12 million loan with a term of 10 years, an amortization of 30 years, and an interest rate of 5.75 percent. The annual debt service was approximately $840,000, with a remaining loan balance of approximately $10,350,000 at the time of refinancing, 8.5 years into the loan term. Defeasance and refinancing transactions costs totaled slightly more than $950,000.
Colliers obtained competitive bids for a new loan sized to 100 percent of refinancing costs, and recommended a nonrecourse option with a 10-year fixed rate of 4.50 percent, amortized over 30 years and new annual debt service of approximately $690,000. This resulted in an increase in pre-tax net cash flow of $150,000 to the borrower. Additionally, the client’s tax professional advised that a significant portion of the defeasance costs and transactions fees would provide valuable tax benefits to the client. Between the reduction in debt service and the value of tax deductions, the time to recoup cost was relatively short. Moreover, given that the borrower could refinance to a lower rate with no cash out of pocket and eliminate both refinance risk in 18 months and interest rate risk for 10 years, defeasance and refinancing made sense.
Sometimes defeasance is not feasible. A loan may be locked out from prepayment, deals with longer remaining terms may be simply too expensive to refinance.
On the other hand, borrowers often choose to defer defeasance for loans with less than 12 months remaining until the open period or maturity. In this scenario, Colliers has used forward rate commitments with insurance companies and banks to rate lock for up to 12 months in advance of refinancing to significantly reduce defeasance costs or eliminate them altogether.
In summary, borrowers who have loans with defeasance provisions should have a qualified party model defeasance based on the specific loan document provisions now. Even if it is not feasible to use loan defeasance now, borrowers should request periodic real-time updates of the defeasance cost. If borrowers are 12 to 24 months from maturity or open prepayment period, they are likely close to the sweet spot for refinancing to a lower rate. Such preparation now will better position borrowers to move quickly when they determine the time is right.
Thomas Welch is senior vice president at Colliers International in Boston. Contact him at Thomas.Welch@colliers.com.
John Poole is an associate of the capital markets team at Colliers International in Boston. Contact him at John.Poole@colliers.com.
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