Negotiating Defeasance Provisions at Origination Can Materially Impact the Bottom Line

Real Estate Issues, Spring 2007 by Henner, Cheryl Pavic

DEFEASANCE IS A PROCESS BY WHICH BORROWERS OBTAIN A release of their properties-typically for the purpose of selling or refinancing-from a mortgage that has been securitized. Once loans are securitized, lenders have little flexibility in changing the provisions established at origination. Because of this restriction, understanding and being able to negotiate defeasance provisions in the term sheet of a new loan go a long way in mitigating future defeasance costs.

UNDERSTANDING DEFEASANCE

Understanding defeasance provisions and their impact on the borrower's bottom line when negotiating the terms of a new loan can save money and prevent surprises when it is time to defease. securitized commercial real estate loans are typically held in a structure called a real estate mortgage investment conduit, or REMIC. The Internal Revenue Code and Treasury Regulations promulgated under the code outline the governance of REMICs. After originating and securitizing the loan, lenders have little flexibility in changing the provisions negotiated at origination because of the restrictions these regulations place on lenders.

The concept of defeasance originated in the municipal bond market and in the 1990s was adapted to the commercial real estate market in response to the increasing securitization of fixed-rate loans. To make these securitizations attractive to investors, prepayment on loans was restricted, enabling predictable cash flows. Loan documents first included defeasance provisions in 1998 to create an avenue for borrowers to exit a securitized loan for a sale or refinance.

Often, defeasance is the only mechanism borrowers can use to release property from a securitized mortgage lien. The process allows borrowers to purchase a portfolio of high-quality government securities, commonly called defeasance collateral, to serve as a substitute for the property collateral identified at loan origination. But borrowers who pay attention to defeasance provisions and negotiate favorable terms at the onset of loan origination can avoid additional costs related to this sometime arduous process.

This article suggests that certain provisions provide borrowers with flexibility if and when they choose to defease a loan. In the suggested language, certain terms are bracketed to indicate that terms may differ by lender, though the substance should remain the same.

AVOIDING LONG LOCKOUT PERIODS

Frequently, the first thing many borrowers notice in loan documents is a provision related to the earliest date-the lockout expiration date-that borrowers can defease the loan. Regulations mandate that securitized loans cannot be defeased until two years after the date of securitization. The period from origination to the date two years later is called the REMIC prohibition period. A defeasance provision in loan documents should allow borrowers to defease upon the expiration of this period. The lockout expiration date is the date a securitized loan first becomes eligible for defeasance. To ensure borrowers have the greatest flexibility in timing defeasance, it is important that the lockout expiration date immediately follows expiration of the REMIC prohibition period.

An example of desirable language is: "Borrower may cause the release of the property from the lien of the security instrument at any time after the earlier of: (i) three (3) years from the date of the origination of this Note, or (ii) two (2) years from the "startup day," within the meaning of Section 860G(a)(9) of the Internal Revenue Code of 1986, as amended, of a "real estate mortgage investment conduit, that holds this Note."

DEFEASING TO THE PREPAYMENT DATE VS. THE MATURITY DATE

Borrowers may have the option of prepaying a loan anytime from one month to six months before maturity of a loan without penalty or premium. The date on which borrowers may prepay the loan is the prepayment date, and the period from the prepayment date to maturity is called the prepayment period or open period. A defeasance provision typically requires borrowers to purchase substitute collateral that provides for payments from the date of defeasance through the maturity date, without regard to whether a prepayment right exists in loan documents.

Savvy borrowers have been successful in negotiating terms that allow them to purchase defeasance collateral to provide for payments through the start of the open period. As a result, borrowers have a chance to realize substantial securities portfolio cost savings by eliminating the final months' interest payments.

In some cases, however, purchasing defeasance collateral that provides for payments up to the start of the open period may actually be more expensive than purchasing defeasance collateral that provides for payments through any payment date within the open period. This scenario, typical for loans with several years remaining to maturity, is true if at the time of defeasance a U.S. government agency has not yet issued securities that will mature in time to cover the final loan payment on or close to the desired balloon payment date.