Knowledge of defeasance presents opportunity to add value and earn business

John Hosmer, chief operating officer, Commercial Defeasance LLC

As published in Scotsman Guide's Commercial Edition, August 2005.

With commercial real estate loan production at historically high levels — up nearly 20 percent in the past year, according to the Mortgage Bankers Association — borrowers are savvier and more motivated than ever. As a broker, your ability to earn business in this highly competitive environment depends, in part, on your ability to add value to the process. A thorough knowledge of defeasance, a mandatory process in many loan documents for borrowers seeking to refinance or sell, can help you reach these goals.

The ABCs of defeasance
It is essential for brokers to understand the meaning of defeasance and its importance. Put simply, defeasance is a substitution of collateral. Typically, the borrower uses proceeds from a refinance or sale to purchase a portfolio of U.S. government securities. The redemption of principal and interest from the securities is sufficient to make the remaining debt-service payments. The lender then releases the real estate from the lien of the mortgage, the note remains in place and debt-service payments are made as scheduled. The process generally takes about 30 days and involves several parties, including attorneys, accountants, a loan servicer, rating agencies (depending on the size of the loan) and, usually, a defeasance consultant.

Since 1998, nearly every fixed-rate Commercial Mortgage Backed Securities (CMBS) loan has included defeasance as the standard form of call protection. Even funding sources that do not regularly securitize their loans have incorporated defeasance provisions into their loan documents. This preserves the option to securitize should they need to do so. With defeasance becoming more prevalent, you will often be unable to place a borrower in a new loan unless the existing loan is defeased.

A borrower analyzing a sale or refinance opportunity needs to know what the defeasance will cost. The total cost is made up of two components: the securities cost and transaction fees. The cost to purchase the securities is a function of the spread between the coupon on the existing loan and the yield on the securities portfolio on the date the securities are purchased. Transaction costs include the fees of the parties involved in the process.

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