As property-value appreciation has pushed real estate investors to pull out built-up equity, multifamily investors are gaining experience defeasing securitized mortgages. And the roster of expert advisers that borrowers can tap to manage the multi-faceted defeasance process continues to burgeon.
That’s important because borrowers using conduit lenders must nearly always defease their loans if they want to sell or refinance to tap rising equity.
And now that this complex “collateral substitution” endeavor has become so popular, defeasance specialists are offering borrowers expertise in negotiating corresponding elements of new conduit loans. Depending on a loan’s amount and terms, some of this practical advice can end up saving borrowers quite a lot of money if they opt to defease, according to consultants.
In defeasance, a borrower invests proceeds from a sale or refinancing transaction into securities which pay enough principal and interest to cover the remaining debt-service payments on the original loan. The securities are substituted for the property that was initially pledged as collateral, and the real estate is released from the mortgage lien.
Advisers can help borrowers tailor agreements to do everything from specifying the shortest legal lock-out period to giving them a share in residual “float” assets that may arise from disconnects between debt-service payments and maturity dates. Experts from capital strategist Chatham Financial, defeasance specialist Waterstone Capital Advisors and law firm Kilpatrick Stockton LLP provided structural and language recommendations aimed at optimizing the borrower’s position.
According to a recent report from JPMorgan Securities, apartment-secured mortgages represent less than 20 percent (roughly $112 billion) of outstanding conduit loans, but account for nearly 30 percent (measured by principal balance) of loans that have been defeased. Historically, the multifamily sector has accounted for well over 40 percent of the individual loans defeased, according to an analysis by Moody’s Investors Service.
Multifamily investors have generally seen stronger appreciation gains than investors in other categories of real estate, so they are more likely to pursue the equity “trapped” by conduit mortgages that don’t mature for several more years. “The consensus seems to be that the over-weighted multifamily defeasance activity is a reflection of the stronger cap-rate erosion” relative to other income-property categories, said Jodi Eppler, a director in Chatham Financial’s defeasance group.
Borrowers should aim to build as much defeasance-related flexibility as possible into term sheets and then have defeasance experts review the proposed terms, counseled Eppler. “That helps make sure you’re giving yourself (optimal) flexibility before you sign anything.”
One relatively simple strategy pertains to specifying the lock-out period during which defeasance or prepayment is strictly prohibited. A lot of borrowers have signed loan documents specifying that the lock-out ends on the later of a designated expiration date or two years after the loan formally gets securitized into a mortgage-backed securities issue (essentially, the date the securities certificates are issued).
The reason for this provision: The rules governing the tax status of commercial mortgage-backed securities (CMBS) bondholder trusts prohibit defeasance for two years after securitization (also known as the trust’s “start-up day”), said Mike Schoenstein, a Waterstone Capital principal.
And as he and Eppler stressed, there’s just no reason for a borrower to agree to any later expiration of the lockout period.
“You should never be locked out from defeasance for more than two years after the start-up day,” Eppler advised.
A lot of borrowers who signed loan documents designating a lockout expiration date beyond two years from the start-up day subsequently seek modifications shortening the lockout period, said Stephanie Westfield, a defeasance specialist at Kilpatrick Stockton. But the rules for CMBS pools don’t allow these modifications, she noted, in many cases leaving borrowers locked out from defeasance for as long as four years.
Controlling the process
Even more important, for several reasons, is language giving the borrower the right to designate the so-called “successor borrower” entity that will technically own the government securities pledged as the replacement collateral and make the debt-service payments. Relinquishing that right to the lender or loan servicer means the borrower loses the ability to engage an independent defeasance consultant that will set up the special-purpose entity successor and recommend a “basket” of collateral securities most optimal to the borrower’s position, according to experts.
“You want to be able to go out and find [a successor borrower] that’s going to return the most value to you as borrower,” Eppler stressed. Hence loan documents should allow this.
A third-party consultant also has the ability to hold an “auction” allowing securities sellers to compete for the business, and ideally will not have any ties to a specific broker-dealer.
“We believe it is important to have the defeasance portfolio be placed in a competitive bid environment with major brokers in order to ensure competitive pricing,” said Schoenstein.
Buying the best collateral
At origination, borrower representatives should also aim to build as much flexibility as possible into the basket of securities to be purchased on behalf of the successor borrower, the experts advised. This means retaining the option to purchase Fannie Mae and Freddie Mac securities, which tend to generate higher yields than Treasury bonds and lower the basket’s purchase price, Westfield said.
But she also cautioned that ratings agencies and CMBS bond buyers may prefer that lenders define the defeasance collateral as “direct non-callable obligations of the U.S. Government.”
Borrowers should aim to avoid that clause, as it’s a stricter standard than the rules for CMBS pools, which require only that the securities be “government securities” within the meaning of the Investment Company Act of 1940 (including Fannies and Freddies).
In addition to better yields, agency securities may well provide interest payment schedules more favorable to the successor borrower than Treasuries, said Eppler of Chatham. And for particularly large defeasance transactions, Fannie or Freddie might customize a bond that exactly matches the cash flows of the underlying debt—creating near perfect efficiency in the replacement collateral.
Keeping any extra cash
Control over the successor borrower’s selection can also have a substantial benefit when it comes to provisions allowing the borrower to share in any residual “float” interest or securities value as the replacement collateral payments wind down at the end of the loan term. For larger loans, this residual value can run into six figures, experts said.
Schoenstein cited the “arbitrage opportunity” that might arise if loan documents specify that defeasance securities continue paying until the loan’s original maturity date, rather than the date a loan opens to penalty-free prepayment (90 days earlier is a common practice today). In this case the successor borrower might obtain third-party financing to pay off the loan when it opens for prepayment, reaping value in the remaining securities if it’s greater than the loan balance, he explained.
In other cases it may be impossible to make all the debt-service payment schedules precisely coincide with the defeased loan’s maturity or prepayment date, likewise potentially leaving value within the remaining basket of assets. “If you have to go with the bank’s choice of a successor borrower, the servicer has no obligation to share any of the residual value,” Eppler said.
The experts suggested that borrower representatives do their best to negotiate “side agreements” with defeasance consultants (and in turn successor borrowers) allowing the borrower to share in any residual float.
Getting the timing right
Eppler also recommends loan language retaining the flexibility to time the replacement collateral’s ending payoff to a date “within the open-to-prepayment window” rather than at the loan maturity date or prepayment date.
“You want to be able to select the date to which you’ll defease,” said Eppler. “The prepayment date isn’t necessarily going to be the least expensive (payoff date); it could be a month into the prepayment period.” Hence borrowers should seek language confirming the ability to purchase securities closing out the payoff “any time between the beginning of the prepayment period and the loan’s maturity,” Eppler said.
If loan documents aren’t crystal clear on this point, loan servicers might deny requests to purchase securities slated to expire when the loan opens for prepayment, cautioned Westfield of Kirkpatrick Stockton. That’s because documents governing bondholder trusts typically prevent them from agreeing to alter the timing of payments or the maturity date for the loans they hold, she elaborated.
“That’s one more reason borrowers need to have their documents reviewed and negotiated carefully,” Westfield said, “to make certain they accomplish their goals.”
Some conduit lenders may even be willing to negotiate extensive open-to-prepayment periods, perhaps as long as a year or two or even longer under some circumstances, Eppler said. However, they’ll expect to be compensated for this borrower-friendly feature, she added.