When commercial real estate (CRE) borrowers mortgage a property, they anticipate making a stream of monthly payments to the lender. In turn, the lender bases its profit on how much interest the borrower will pay over the loan term. Therefore, anything that threatens the payment stream from the borrower threatens the lenders profits. Frankly, the last thing a borrower would want to do would be to stand between a lender and its profits. But that is exactly what happens when the borrower decides to prepay its fixed-rate loan. This article is about loan defeasance.
Thus, the lender takes steps to safeguard its profits through prepayment penalties. Specifically, two popular ways for lenders to ameliorate prepayment risk is through yield maintenance and loan defeasance. We covered yield maintenance in the article Yield Maintenance Simplified. Likewise, in this article we’ll deconstruct loan defeasance so that its meaning is clear. Also, we’ll discuss the best practices for executing defeasance and compare it with yield maintenance. Then, we’ll describe why loan defeasance looms large in the CMBS market. Finally, we’ll close out the article by answering some pertinent frequently asked questions.
What is Loan Defeasance?
Loan defeasance is a provision that lenders commonly specify in the CRE lending agreement, as we discuss below.
Loan Defeasance Scenario
Picture what happens when a CRE borrower wants to refinance or sell property. Consequently, this will truncate the payments of principal and interest on the original loan. Without doubt, the loser is the lender. That’s because the lender requires on-time payments so that it can collect all of its interest. Under a loan defeasance clause, the borrower doesn’t directly repay the loan. Instead, it sells or refinances the property, using the proceeds to purchase suitable U.S. government debt, the defeasance collateral. Importantly, that debt matures at the same time as the original loan. The loan transfers to a successor borrower who receives the periodic interest from the defeasance collateral. In turn, the successor passes the interest to the original lender. In this way, the lender collects the interest it anticipated all along, without suffering a prepayment loss.
Loan Defeasance Premium
Typically, borrowers refinance their CRE loans only when interest rates fall. Obviously, lower interest rates mean lower borrowing costs. Additionally, this also means lower interest rates on the Treasury debt that will serve as defeasance collateral. In order to make the lender whole, the borrower will have to purchase extra Treasury debt. In this way, the monthly interest payments match those of the original loan. The amount of extra Treasury debt purchased to match the loan’s interest requirements is the defeasance premium.
The defeasance-related terms in the following sections are important to understand.
Early Prepayment Date
Normally, CRE loans do not charge prepayment penalties from the early prepayment date to the loan term end. Typically, the early prepayment date is six months before the end of the loan term.
A portfolio of government debt securities that replaces the CRE property as loan collateral. Typically composed of U.S. Treasury debt, but debt from agencies like Fannie Mae and Freddie Mac sometimes are acceptable. Normally, the term of defeasance collateral matches that of the original CRE loan.
An entity that takes assignment of the defeasance collateral and assumes the loan’s remaining financial obligations.
This is the value of defeasance collateral in excess of the pledge requirement for the loan. The successor borrower reaps the benefits of residual value, which it might share with the borrower. Residual value can arise because the defeasance collateral matures after the early prepayment date. Also, residual value can arise when defeasance collateral interest arrives before needed for an outgoing loan payment.
This stands for collateralized mortgage-backed securities. To be clear, these are pass-through securities that receive backing from pools of mortgages. Sponsors assemble these mortgage pools and issue CMBS to investors. Explicitly, the principal and interest from the pools pass to the CMBS investors. Obviously, prepayments by the mortgage borrowers in the pools reduce payments to CMBS holders, lowering their return on investment. Thus, prepayment penalties compensate the CMBS investors from one source of yield loss. Read our article, CMBS Loans: Guide to Commercial Mortgage-Backed Securities, for more information about CMBS.
This is a Real Estate Mortgage Investment Conduit, which is the tax-free entity that sponsors create when issuing CMBS. Unsurprisingly, there are many regulations affecting REMICs, including ones regarding what REMICs can use as collateral for their CMBS. Generally, a REMIC can invest only in qualified mortgages. Therefore, any other investments can cause REMICs to lose their tax-free status. To be clear, tax regulations permit REMICs to hold government securities (usually Treasury bonds) as substitute collateral if:
- The mortgage agreement permits this substitution, i.e., through a defeasance clause.
- The substitution releases the original lien on the mortgage property.
- The lien release doesn’t occur within two years of REMIC startup.
A REMIC must adhere to these rules in order to maintain its tax-free status.
Best Practices for Executing a Defeasance
Normally, a CRE loan contract will have a defeasance clause that specifies the acceptable conditions for executing the defeasance. The defeasance clause defines the boundaries for the best practices available under the loan terms. The following sections review these best practices.
Reviewing the Mortgage Documents
Defeasance can only proceed if the mortgage agreement allows it. Furthermore, the borrower must confirm with the REMIC (if any) that the defeasance clause follows Treasury rules. The borrower should also verify that the defeasance clause supports the prepayment time requirements. For example, the REMIC must be at least two years old before the defeasance can proceed. Also, a defeasance usually requires 30 days written notice and up to 45 days to complete. Moreover, the loan agreement might include a lockout period preventing defeasance during the first several years of the mortgage. Sometimes, the lender will relax some of its requirements for loan defeasance.
Analyzing the Cost of Defeasance
Defeasance incurs several costs, including:
- The cost to purchase the government securities that will function as defeasance collateral. The cost depends in part upon the spread between the current yields on the government securities and the loan. Usually, the cost of the government securities will be greater than the existing mortgage balance — i.e., the defeasance premium.
- Transaction costs required to consummate the defeasance transaction. These may include lender processing fees, defeasance consultant fees, lawyers’ fees, successor borrower fee, and broker/dealer fees. Additional fees might include securities intermediary fees, accounts fees and possibly rating agency costs. Together, these transaction fees might range from $50,000 to $100,000.
The borrower might save some money by purchasing government securities that mature on the early prepayment date. This would save about six-months’ worth of interest expense. Another money saver is to use government securities from Fannie Mae or Freddie Mac instead of U.S. Treasury bonds. Explicitly, this reduces the cost of the defeasance collateral because these alternate securities have higher yields.
Structuring the Transaction
The defeasance transaction results from the sale or refinancing of the mortgaged property. A best practice is for the property owner to condition the sale or refinancing upon successful completion of the defeasance. The owner should also inform the lender as soon as possible about the desire for defeasance. Otherwise, the lender might raise objections that kibosh the entire deal. The refinancing or sale letter should also condition the transaction on the cooperation from the original lender and/or buyer. In this case, cooperation means timely deliveries into escrow, including sale/refinancing proceeds and release approval for the money.
Even though the successor borrower assumes responsibility for the loan following defeasance, the original borrower may face certain liabilities. For example, the borrower will be on the hook for misrepresentation, fraud, undisclosed hazardous materials, and other unkind acts. Furthermore, the lender may require additional statements and guarantees from the borrower. Naturally, the loan document should address all these things. Moreover, best practice indicates that borrowers:
- Resist attempts to have them guarantee that the defeasance collateral is sufficient. Rather, that job should go to the successor borrower.
- Agree only to be liable for the purchase and perfection of the defeasance collateral, not any other responsibility.
- Have a full understanding on the various documents used in the defeasance transaction. These include the Defeasance Pledge and Security Agreement, the Defeasance Account Agreement, and the Certificate Borrower. Other documents include the Defeasance Assignment, Assumption and Release Agreement, the Waiver and Consent, and the Rating Agency Confirmation.
Produce Legal and Accounting Opinions
Part of best practice is to produce quality expert opinions to support the defeasance transaction. These include:
- Nonconsolidation Opinion: The borrower’s lawyer affirms that the successor borrower won’t consolidate assets with borrower’s assets in bankruptcy court.
- Special Interest Opinion: The lender’s lawyer confirms the trust has a valid first-priority security interest in the substitute collateral and its proceeds.
- Enforceability and Authority Opinion: Borrower confirms that the defeasance documents are enforceable against it and executable by it.
- REMIC Opinion: The original or successor borrower confirms the defeasance transaction won’t cause the REMIC to pay taxes or lose status.
- Accountant’s Report: The accountant agrees that there will be enough defeasance collateral to pay the remainder of the defeased loan.
Loan Defeasance vs. Yield Maintenance
As described in Yield Maintenance Simplified, yield maintenance requires a penalty payment so that the lender receives the original loan yield. It involves the computation of a replacement rate that will make the lender whole with regard to yield. This is a penalty that applies whether interest rates rise or fall.
Defeasance is a more complicated procedure. It is not necessarily a penalty, although it can be costly. But there are times when defeasance may actually produce cash for the borrower. For example, this can occur when interest rates are higher than those on the original loan. Consequently, this allows the borrower to purchase replacement collateral at a discount.
Defeasance and CMBS Loans
We have discussed how REMICs issue CMBS to investors backed by pools of qualified mortgages. Defeasance assures CMBS investors that they will receive the yield they were expecting despite prepayments. Defeasance does not help yields when mortgage holders default on their loans.
Loan Defeasance FAQs
What is a defeasance clause in real estate?
It is part of a loan agreement specifying if and how defeasance is available when prepaying a CRE loan. It describes the various requirements that participants must meet for defeasance to proceed.
What is a defeasance period?
This is the period over which the successor borrower will make defeasance payments. Prepayments trigger the defeasance period. The period can end at the same time as the original loan, or up to early prepayment date. This date is six months before the end of loan term.
Are defeasance fees deductible?
Yes, companies can deduct these fees as interest expense. The IRS acknowledged the defeasance costs deductibility in Rev. Rule 85-42, which describes “in-substance defeasance.” However, the defeasance fee may be taxable to the lender if not offset by exchange expenses.
What is in-substance defeasance?
This is the process of purchasing substitute collateral and placing it in an irrevocable trust. The yield from the substitute collateral makes the lender whole with regard to yield. The securities that cover the debt do not have to appear on the balance sheet.
How are prepayment clauses calculated?
The lender compares the yield from the original mortgage to the yield due to loan prepayment. Then the lender calculates the dollar loss due to prepayment. Yield maintenance and loan defeasance remedy the loss of yield, but in different ways.