What is defeasance?

Real Estate Weekly, Jan 11, 2006 by John Hosmer

What is defeasance? 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 that is sufficient to make all of the remaining debt service payments required by the note. The securities are pledged to the lender, and the lender releases the real estate from the lien of the mortgage. The note remains outstanding but is assigned by the borrower to an unaffiliated successor borrower, who makes the ongoing debt service payments.

Why are you hearing quite a lot about defeasance these days? For borrowers with loans securitized in the commercial mortgage-backed securities (CMBS) market--many of which prohibit mezzanine financing--the two primary vehicles for extracting equity are selling or refinancing. In order to do either, a fixed-rate CMBS loan originated after 1998 typically must be defeased. Since 1998 all originators of fixedrate CMBS product have incorporated defeasance provisions in their form loan documents, because investors in commercial mortgage-backed securities are willing to pay more for bonds backed by mortgages that require defeasance instead of a yield maintenance cash prepayment. As a result, nearly all fixed-rate CMBS loans prohibit a simple cash prepayment and require that the loan be defeased in order for the borrower to sell or refinance.

As many of the loans originated this year will be fixed rate loans with ten year terms, even if originators across the entire industry ceased including defeasance in their loans today (which is extremely unlikely), there would still be loans originated this year being defeased in 2016. Suffice it to say that defeasance will be around for a while, so it's worth understanding.

It sounds fairly simple, but the process involves a loan servicer, attorneys, an accountant, rating agencies, a securities intermediary, the title company, the refinance lender or the buyer's lender, and usually, a defeasance consultant. A defeasance generally takes thirty days to complete, and as one might imagine, coordinating all the parties to close the defeasance transaction contemporaneously with the closing of the related sale or refinancing is no easy task.

In addition to reviewing defeasance documents and delivering legal opinion letters, an accountant's sufficiency report and other items on the servicer's counsel's checklist, a defeasance also involves identifying and purchasing qualified government securities that mature prior to, but as close as possible to, each remaining payment date under the note. For a loan with a five year remaining term, the defeasance collateral could consist of as many as forty individual securities. An experienced defeasance consultant can ensure that the entire defeasance process goes smoothly, so the borrower can focus on the related sale or refinancing.

Any borrower analyzing a sale or refinancing opportunity needs to know what the defeasance will cost. The total cost is made up of two components: the securities cost and the transaction fees. The cost to purchase the securities is a function of the spread between the interest rate on the loan to be defeased and the yield on the securities portfolio on the date the securities are purchased. Transaction costs include the fees of the various parties involved in the typical defeasance transaction. Defeasance cost estimates can be obtained easily from free online calculators, like the one found at www.DefeaseWithEase.com. In order to use an on-line calculator you will need to enter the original loan amount, the date of the note, the loan term, the interest rate, the interest accrual method (30/360 or actual/ 360), the amortization period and the name of the loan servicer. When using any calculator, keep in mind that it only provides an estimate as of the date that the calculation is run. The actual cost of the securities is not determined until they are purchased at closing. Because the cost of every security fluctuates in the market from one second to the next, the actual cost of the securities could be higher or lower than any prior estimate obtained from a calculator or defeasance consultant, even one obtained on the day the securities are purchased.

The most important thing to remember when evaluating alternatives for extracting the equity from a property subject to a loan that requires defeasance is to complete the entire analysis. Don't be deterred by high defeasance premiums. The results of a thorough comparison of the alternatives may make defeasance a more compelling alternative, because the same interest rate factors that make defeasance more expensive also make interest rates lower and increase proceeds on new loans.

Conversely, rising interest rates make defeasance cheaper but make interest rates higher and proceeds lower on new loans. Interest rates are still near historic lows, so now is still a good time to get educated about defeasance and consider refinancing or selling and rolling the proceeds into a new project, especially if an existing loan (with a large balloon payment) is within a few years of maturity.