Defeasance means substituting one piece of collateral for another. While that definition sounds simple enough, the defeasance process itself can be quite complicated.
For investors borrowing money to purchase commercial real estate, having a defeasance clause in the loan documents is a fact of life in finance. It’s also important for commercial real estate brokers to understand the defeasance process because it lets buyers, sellers, and lenders get what they want – and helps to get deals done.
Why Do Lenders Include A Defeasance Clause In Loan Documents?
Defeasance and CMBS (Commercial Mortgage-Backed Securities) go hand in hand. When banks sell such securities, buyers are promised a specific income over a specific amount of time that generates a specific yield. It is important to remember that CMBS are just like bonds that pay a fixed rate for a fixed period of time.
If borrowers refinance or pay off the mortgage loan early, the interest income flow on the CMBS is interrupted. So, lenders require that borrowers substitute the real estate that originally secured the loan with safe U.S. securities such as Treasury bills that will generate the same yield for the holder of the CMBS.
Almost all commercial real estate loans have defeasance clauses, even if the loan isn’t initially part of a REMIC (real estate mortgage investment conduit). This gives the lender the option of offering the loan as a CMBS at a later date if it chooses to do so.
When Do Borrowers Use The Defeasance Process?
Borrowers who want to refinance or sell the commercial property use the defeasance process to release the mortgage lien on the real property. However, the IRS places some restrictions on CMBS holders – and consequently on lenders and on borrowers:
- There is a two-year lockout period from the time the loan is securitized before a mortgage release – or defeasance – can occur.
- Original loan documents must contain a defeasance clause and can not be amended after the fact.
- Substitute defeasance collateral can only consist of noncallable government securities.
Making Defeasance Easier For Borrowers
There are two things a borrower can negotiate with the lender, in order to make defeasance easier:
- In addition to U.S. Treasuries, ask the lender to accept other government securities from agencies such as Ginnie Mae, Fannie Mae, or Sallie Mae as defeasance collateral. These securities can be more cost-effective for the borrower: because they have higher yields, fewer would need to be purchased as replacement collateral.
- Request the lender to allow both defeasance and yield maintenance if the loan is prepaid. Depending on current interest rates and bond yields, yield maintenance may be more cost effective for the borrower than defeasance.
The Difference Between Defeasance And Yield Maintenance
Defeasance and yield maintenance accomplish the same thing but in different ways.
Defeasance replaces the original collateral of the loan and the original loan stays in place. Yield maintenance is the prepayment of the loan which includes the outstanding balance plus a prepayment penalty which effectively replaces the income lost to the lender due to sale or refinancing.
Borrowers often retain the services of a professional defeasance consultant to determine whether defeasance or yield maintenance makes more financial sense for the borrower.
How Does The Defeasance Process Work?
The defeasance process normally takes between 30 and 45 days and follows these 10 steps:
1. Borrower engages the services of a defeasance consultant to determine if defeasance is allowed under the terms of the loan and if defeasance is the best financial choice for the borrower. The consultant will analyze the loan documents, current loan balance, market interest rates, and loan terms.
2. Provide the lender or loan servicer with notice of intent to defease and a good faith deposit to offset some of the borrower defeasance costs incurred by the lender.
3. Defeasement consultant begins coordinating the activities of all parties involved in the defeasance including the borrower, loan servicer, securities custodian, accountant, rating agencies, title company, and attorneys.
4. Lender drafts the defeasance agreement for all parties to review and may ask the borrower for additional documents relating to the defeasance.
5. A successor borrower is formed. This is a special purpose entity created to assume the repayment of the original loan and ownership of substitute collateral.
6. Defeasance collateral is structured into a securities portfolio designed to generate the same income as the original loan collateral.
7. CPA reviews the defeasement collateral to determine if the replacement securities will generate sufficient income to cover loan payments due to maturity.
8. Bond credit rating agencies will analyze and approve the transaction if called for in the defeasement provisions in the original loan documents. Generally, credit rating agency approval is not required if the loan is less than $20 million or if the loan represents a small percentage of the loan pool’s total collateral.
9. Closing takes place after the borrower agrees to purchase the selected replacement defeasance collateral. Then:
- Borrower assigns its rights and obligations under the loan documents – and the defeasance collateral – to the successor borrower,
- Lien on the original real property collateral is released by the lender, allowing the real estate to be sold or refinanced,
- Property sales proceeds are placed in an escrow account used to purchase the defeasance collateral,
- Collateral is purchased and assigned to the successor borrower,
- A defeasement account is created to hold the defeasance collateral and a securities intermediary makes the loan payments from the cash generated by the collateral.
10. Residual value – or extra money – is sometimes created when the replacement defeasance collateral generates more money than what is needed to meet the loan payment obligations. The borrower’s defeasement consultant will negotiate when and how much of any residual value the borrower will receive.