Defeasance activity has slowed significantly in 2008 and will likely continue at a plodding pace through the rest of the year.
With a lack of liquidity in the market and Treasury rates remaining historically low, the market for defeasance transactions has dwindled. Just 423 loans totaling $3 billion were defeased through the second quarter of 2008, compared to a record 1,663 loans totaling $19.4 billion that were defeased during the same period in 2007, according to Moody's Investors Service.
That's a roughly 75 percent drop in the number of transactions and an 84 percent decline in dollar volume year-over-year through the second quarter of 2008.
In broad terms, defeasance is a collateral substitution process allowing borrowers to prepay conduit loans. The borrower replaces the lender's security, usually a real property, with government-backed securities such as Treasury notes or securities from Fannie Mae and Freddie Mac. Those securities are sold to a “successor borrower,” an entity that assumes the borrower's obligations under the promissory note. The real estate is then released from the mortgage lien.
The two biggest factors impacting the current slowdown in defeasance transactions are the lack of liquidity from lenders—which has hobbled the property sales market—and the low rate of Treasury notes.
When Treasury rates are low, the cost of defeasance goes up since the borrower has to purchase more securities to match the balance on the existing loan.
“Because Treasury notes are so low right now and cap rates are rising, the cost of defeasance is just prohibitively expensive for many,” said Jodi Eppler, a director at Chatham Financial. “The cost of defeasance has caused people to change their mind on selling a property, especially the smaller guys who have only a $1 million or $2 million loan.”
The fees associated with defeasance are a fixed cost, usually starting at $50,000, a figure that's the same whether you're defeasing a $1 million loan or a $50 million loan. And that's on top of the cost of purchasing securities as collateral.
Longer timelines, more uncertainty
The defeasance market has changed with the times. Most lenders are shying away from larger loans in favor of small ones and offering lower leverage, to minimize risk. For instance, the average defeasance transaction at Chatham Financial has shrunk from about $30 million last year to approximately $6 million today, according to the company.
“The on-book lenders are favoring loans in the $10 million and less range, and so the megadeals, the $60 [million] or $70 million deals, we're really not seeing now,” said Buddy Cramer, founder of defeasance consultant DefeaseIt.
Defeasance transactions are now taking much longer to close. Prior to October 2007, transactions would typically close in about 45 to 60 days after a client initiated the process. But today, many clients begin the process four to six months before they plan to sell, and many transactions will fall through as buyers have trouble finding financing.
Because the multifamily industry is a preferred asset class, with more liquidity available to it than other sectors of commercial real estate, more multifamily loans are going through defeasance today as a percentage of overall volume. Last year, about 20 percent of all defeasance activity handled by Commercial Defeasance, LLC, was for multifamily transactions. Today, that figure has doubled to about 40 percent, according to the company.
And fewer borrowers are using defeasance to refinance their properties than in the past. Last year, refinancing constituted about half of all defeasance activity handled by Commercial Defeasance, but today, that figure is closer to 35 percent, according to the company.
The turmoil facing Fannie Mae and Freddie Mac has also caused a change in the process of defeasing a loan. Many conduit loan borrowers favor Fannie Mae and Freddie Mac securities as the replacement collateral since those securities often have higher yields than Treasury bonds, lowering the cost of defeasance.
“To use agency securities, you have to get servicer and rating-agency approval, and at one time we automatically assumed that the approval would be given,” said Eppler. “But now with the market turmoil, we don't just assume it's going to be OK; we check with the servicer and the ratings agency first.”
In March, Commercial Defeasance launched Custom Hedging Solutions, a business unit aimed at helping borrowers hedge their interest rate risk, in reaction to client requests and has the added value of diversifying the company's business line. Custom Hedging Solutions is headed by Jennifer Imler, who joined Commercial Defeasance earlier this year after spending seven years at Wachovia as a fixed-income derivatives trader.
Chatham also offers this service and in fact was founded as a hedging strategy consultant.
Both companies provide interest-rate caps and swaps that protect borrowers of floating-rate debt from a future up-tick in rates. The units also provide hedging solutions related to defeasance, helping conduit loan borrowers to lock in the cost of their replacement collateral with “Treasury locks” or option products that lock in the cost of defeasance.
With liquidity difficult to find and Treasury rates still low, defeasance consultants are hunkering down, hoping to ride out the current credit crunch. Each company points to the record number of conduit loans written in the last three years as evidence of a strong pipeline.
Still, the outlook is less than clear for the commercial mortgage-backed securities (CMBS) market. CMBS spreads have only spiked further in the wake of the government's bailout of Fannie Mae, Freddie Mac, and AIG, not to mention the bankruptcy of Lehman Brothers. And many balance-sheet lenders have scaled back their lending appetites heading into the autumn.
So, what will it take before the transaction market revives and conduit borrowers begin defeasing again in large numbers?
“There has to be more liquidity and lenders willing to underwrite deals, and right now, it's not happening,” said Eppler. “And it's not just CMBS that stopped lending. When you look at insurance companies, they have not increased their books significantly.”
Treasury bond yields also need to creep up before the cost of defeasance again becomes economically feasible for conduit borrowers. “It's going to take the market settling down,” said Cramer. “And that could take another year.”