By Shawn Hill
As the commercial mortgage-backed securities (CMBS) market continues to rebound, defeasance is also making a comeback. Many of you may wonder what that is. Put simply, defeasance is a substitution of collateral.
More specifically, according to Wikipedia, “defeasance of a securitized commercial mortgage is a process in commercial real estate finance by which a borrower substitutes other income-producing collateral for a piece of real property to facilitate the removal (defeat) of an existing lien (entailment of the property) without paying-off (through a transfer of liquid assets) of the existing note.”
The next logical question is, “Why would I want to substitute collateral and defease a loan?”
There are many reasons to defease a commercial mortgage, chief among them is the desire to refinance the existing debt to find more advantageous financing in the markets. Another key reason is the need to sell a property, and the new borrower either can’t or doesn’t want to assume the loan. In both cases (and any other), it’s critical the loan continue to “perform” within the securitized pool. Thus it needs to keep making its monthly debt service. By substituting collateral, the CMBS loan continues to be paid, while the property owner also achieves his financing goals.
Nearly every fixed-rate commercial real estate loan originated since 1998 requires the borrower to defease the loan to sell or refinance. Defeasance has become so prevalent in securitized real estate loans that life-insurance companies, the U.S. Department of Housing and Urban Development and others seeking to preserve the ability to securitize their loans have incorporated defeasance into their form-loan documents as well.
The Nuts and Bolts of Defeasance
Typically, a defeasance is coordinated to close contemporaneously with a sale or refinance. The borrower uses proceeds from the sale or refinance to purchase a portfolio of U.S. government securities that’s sufficient to make all of the remaining loan payments. The securities are pledged to the lender, and the lender releases the real estate from the lien of the mortgage. The promissory note, which remains outstanding after the defeasance, and the portfolio of securities are assigned by the borrower to an unaffiliated successor borrower that makes the ongoing debt-service payments.
The defeasance process involves a host of professionals, from attorneys and accountants to servicers, trustees and rating agencies. Defeasance is not a simple prepayment. The entire defeasance process typically takes 30 days, on average, of which two to three days are allocated to the closing process.
Every defeasance has two cost components: transaction costs and the cost of the securities that comprise the substituted collateral. The transaction costs consist of the fees of the various parties involved, which generally range from $45,000 to $65,000 in the aggregate, excluding borrower’s counsel’s fee. The transaction costs vary depending on the size of the loan, the complexity of the transaction (i.e., a partial defeasance or a New York-style defeasance), and the fees charged by the servicer of the loan and their legal counsel.