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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2009

Defy Defeasance Dilemmas

For borrowers exiting existing loans, cost savings could be within reach

Borrowers looking to exit an existing real estate loan in today's market often are motivated to refinance or sell as soon as an opportunity presents itself. 

This desire to lock in an exit is justified, considering most lenders' current lack of interest in commercial real estate. Even when borrowers are lucky enough to find a buyer or new financing in today's market, they must still exit the existing loan. For most conduit loans, this means going through a defeasance and paying the fees and penalties associated with that process. 

Commercial mortgage brokers should understand the defeasance process to help clients who want to refinance or otherwise exit an existing loan before its scheduled maturity date. With knowledge of the process, brokers likely can help their clients discover cost savings.

Delineating defeasance

Since 1998, borrowers have been required to defease their existing loan for nearly all conduit loans to remove the lien on their property before the loan's scheduled maturity date. Essentially a substitution of collateral, defeasance requires the borrower to purchase a portfolio of U.S. government securities structured to replicate the cash flow required for the original note.

This substitute collateral is pledged to the lender in lieu of the real property. It is then transferred with the original debt to a new borrower, or "successor."

As with all things real estate, the defeasance process comes at a price. Borrowers must pay third-party costs, which typically range from $50,000 to $110,000. They also must purchase the replacement collateral. 

With the yields on government securities at historic lows, the cost of the replacement collateral is extremely high. A few years ago, the increased defeasance costs resulting from low Treasury rates would have been offset by lower borrowing costs and increased loan proceeds. Today, however, the proceeds are often not enough to cover borrowers' outstanding debt, the defeasance penalty and the third-party costs associated with the refinance or sale process. As a result, many borrowers are desperate to find alternatives or cost-saving methods.

Limited by rules

Borrowers whose loans are held on their lender's balance sheet may find the lender has some flexibility when it comes to modifying loan terms. Rather than requiring a defeasance, some of these lenders may accept a one-time prepayment penalty.

If the loan has been securitized and transferred to a loan servicer, however, borrowers often will find few prepayment alternatives. Most commercial mortgage loan securitizations are held in trusts set up as real estate mortgage-investment conduits (REMICs). This structure allows the trust to act as a pass-through entity for tax purposes.

The Internal Revenue Service rules governing REMIC trusts (see sidebar) limit servicers' ability to modify loans, to an extent. Servicers are further limited by the trust's pooling and servicing agreement, which governs the treatment of commercial mortgage loans within the trust. Even if servicers can modify a loan within the REMIC rules, they may still be limited by this agreement's more-restrictive requirements.

For brokers and their clients, these issues highlight the importance of negotiating favorable loan language at the inception of a loan.

Seeking cost savings

Although it is unlikely that any servicer will remove the defeasance requirement altogether, there are several items that could result in significant savings:

  • Definition of collateral: Borrowers should verify the servicer's interpretation of the type of securities that qualify as replacement collateral. Borrowers should always ask if agency securities or other government-guaranteed securities could be used as part of the defeasance collateral. These types of securities currently yield as many as 70 basis points more than Treasurys. For a $10 million loan with a 5-percent coupon and six years remaining until maturity, for example, using a portfolio comprising a combination of these alternate securities could translate into a savings of $350,000.
  • Purchasing collateral to the open-prepayment window: Borrowers typically must structure the defeasance collateral so that the securities cover payments of as much as and including the payment due on the loan's maturity date. If a loan has a prepay-at-par window that opens a few months before maturity, however, some servicers may allow borrowers to structure the loan to this early prepayment date. 
    This can result in the savings of the present value of several months of interest payments, depending on the length of the loan's open-prepayment window.
  • The new-note defeasance: When refinancing, borrowers should ask about the possibility of conducting a new-note defeasance, especially if their property is in a state that charges a high mortgage-recording tax. In this structure, the REMIC trust assigns the original loan and mortgage to the new lender in exchange for a defeasance note and the pledged defeasance collateral. The borrower and new lender then amend and restate the original note to reflect the terms of the refinance. Because the original note still exists, the borrower must only pay mortgage-recording tax on the amount by which the note has increased. New York; Maryland; Minnesota; Florida; Washington, D.C; and Virginia allow this structure.
  • The defeasance consultant: In addition to helping borrowers navigate the nuances of the defeasance process, a defeasance consultant typically establishes the successor borrower to release the original borrower from the loan's obligations. Over the life of a loan, the value of the collateral held by the successor borrower may increase because of two primary factors: 1. interest income coming from timing mismatches between cash receipts from the defeasance collateral and cash payments over the life of the defeased loan, and 2. the prepayment of a defeased loan during the open-prepayment window. 
    In the prepayment situation, the original borrower was required to purchase securities through the maturity date, but the right to prepay survived the defeasance process. Per the terms of the assignment documents, the successor borrower owns this residual interest income and prepayment value. Many defeasance consultants will share this residual value with the original borrower by offering a present-value payment at the close of the defeasance or a greater share if the borrower waits until the maturity date to share in the final, realized value.

Although most commercial borrowers cannot avoid the defeasance process altogether, with their broker's help, they can realize significant savings in the overall cost of exiting existing debt by exploring the above situations with their servicer and defeasance consultant.


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