Strong real estate appreciation, a low interest-rate environment, and a growing number of eligible loans are driving the growing use of the defeasance process among multifamily borrowers.
In broad terms, defeasance is a collateral substitution process. The borrower takes the proceeds from refinancing or selling a property and buys a portfolio of U.S. government securities. Those securities are substituted for the property and sold to a “successor borrower,” the entity that will own the securities used as replacement collateral, and assume the borrower’s obligations under the promissory note. The real estate is then released from the mortgage lien.
The process is especially popular for borrowers of commercial mortgage-backed securities (CMBS) loans. Beginning in 2000, conduit borrowers looking to extract equity by selling or refinancing the property were required to defease, and the process became the only way these borrowers could access the property’s equity.
So, how can borrowers structure a new CMBS loan to make defeasance easier in the future? Consultants from two leading independent defeasance consulting firms, Commercial Defeasance, Inc., and Chatham Financial, offer tips on how to structure your loan today to make defeasance easier tomorrow.
Borrowers need to look at several areas when structuring a fixed-rate loan with an eye on defeasance, such as the kinds of securities to be purchased, how those securities will be purchased, and who the successor borrower will be. All of the following suggestions give the borrower more flexibility and power over the defeasance process, optimizing their position and maximizing their bottom line.
Targeting agency securities
The borrower or its representatives should demand that loan terms give them the option to purchase a flexible array of securities on behalf of the successor borrower. Specifically, the ability to use securities of government-sponsored enterprises (GSE) like Fannie Mae and Freddie Mac is preferable over the standard loan language that strictly defines defeasance collateral as U.S. Treasury bonds. The GSE bonds offer higher yields and also come with a more reasonable price tag, lowering the overall price of the bundle of securities. “It costs the borrower a lot less to actually execute the defeasance if they can use that kind of collateral instead of just Treasuries,” said Rich Weins, a Kennett Square, Pa.-based director of defeasance services for Chatham Financial.
CMBS bond buyers conservatively favor direct obligations of the U.S. government, even though agency bonds fall under the definition of government securities allowable in CMBS pools. But lenders often include this provision if the borrower or the borrower’s representative pushes for it. “Unless you ask for it, you’re not that likely to be allowed to use agencies,” said Weins.
Purchasing defeasance collateral
How those securities are purchased is another point to consider. The borrower would do best to have the right to purchase the defeasance collateral, rather than appoint someone else to purchase it for them.
“That way, they can make it a competitive process, or at least pick who’s providing the securities,” said Weins. Without that right, “you have no way of guaranteeing that you get the best price because you’re kind of captive,” said Weins.
Some defeasance language mandates that the borrower supply cash that’s then used by the lender or the lender’s agent to purchase the securities. The borrower then would be responsible for any cost or expense associated with it.
In such a scenario, the borrower has no control over the selection of the servicer, and it could be an entity that the borrower prefers not to deal with. “It could wind up going to a servicer who has their own brokerage shop, who exercises the right and says ‘send us the money, we’re going to buy the securities through our desk, and you’ll pay us whatever we say you have to pay us,’” said John Hosmer, CEO of Charlotte, N.C.-based Commercial Defeasance, Inc.
It’s preferable for the borrower to have control over the purchase, so “they can go out into the marketplace and get the best deal that they can get for the securities,” said Hosmer.
Naming the successor borrower
Once it’s decided what securities will be purchased and how they will be purchased, the borrower also wants to make sure that they have the right to name the successor borrower, according to Weins. Having that control can help the borrower ensure competitive pricing and find the successor borrower that will return the most value. If the borrower has that right, they also can direct their defeasance consultant to hold a competitive auction, allowing securities sellers to bid for the business.
But that right is often given away to the lender or another third party in standard defeasance-related loan terms. If requested, however, the language can be modified to give the borrower more control over the process.
Minimum lock-out period
The Internal Revenue Service rules that stipulate the tax status of CMBS trusts mandate a two-year “lock-out” period—the time-span when defeasance is prohibited—starting at the date of securitization. Borrowers would do best to limit the lock-out period to this mandatory two-year span and avoid any loan document language that heaps additional temporal conditions on their ability to defease.
“You really want the lock-out period to be defined as the REMIC [Real Estate Mortgage Investment Conduit] lock-out period—two years from the startup date,” said Hosmer.
The typical defeasance language defines the period as ending “upon the earlier to occur of two years after the startup date of the REMIC trust, or three years from the date of the note.” But Hosmer said that, every once in a while, he’ll see language in a loan document that says “the later of four years from the date of the note, or two years from the lock-out period.”
“You could potentially have a two-year period where the borrower would like to defease—they’ve got a lot of appreciation, they want to refinance, they want to sell even as early as three years after the original loan was made—and they can’t,” said Hosmer. “They have to wait until the lock-out period as defined in the note expires.”
And once the loan document is signed, this provision is written in stone: The rules governing pools of CMBS don’t allow any after-the-fact modifications on the lock-out period.
Best interest rate environment
Defeasance costs change up until the date the defeasance takes place due to shifting interest rates. When interest rates are low, the rate at which a borrower can refinance a property is obviously beneficial. But the bad news is, the cost of the defeasance portfolio goes up in a low interest-rate environment—as rates go down, bonds become more expensive. In a high interest-rate environment, the reverse is true: Bonds are less expensive, but the refinancing rate is less beneficial.
When confronted with the high cost of the defeasance portfolio in a low interest-rate environment, “there’s sort of a natural, visceral reaction from borrowers when they see that kind of prepayment fee,” said Hosmer. Because borrowers pursue defeasance when property values have increased, they “gain more in loan proceeds when interest rates are down than what it costs in additional purchase price on the defeasance collateral,” he said. “It’s a little counterintuitive.”
For example, a borrower has a $15 million principal balance on a conduit loan with a 6.5 percent interest rate. The borrower may have to buy $16.5 million in bonds to defease the loan, since the bonds are yielding only 4.5 percent. But since the property value has increased and interest rates are lower than when the loan was originated, the borrower could borrow $19 million against the property, netting $2.5 million in equity.
“Usually you’re refinancing for more than you owe,” said Weins. “The good news on the refinancing side outweighs the bad news on the defeasance side.”
