Borrowers are often fearful of defeasance, but why? With the recent low interest-rate environment fresh in everyone’s minds, defeasance has built up a negative connotation among owners and brokers—particularly those associated with self-storage properties—with many loans being assumed rather than defeased over the last few years. However, as loans that were originated from 2004 to 2007 approach maturity, defeasance can actually be cost beneficial for many self-storage property owners.
Most often used in commercial real estate as the prepayment requirement on conduit/commercial mortgage-backed security (CMBS) loans, defeasance is the process of releasing a commercial property from the lien of the mortgage and replacing it with a portfolio of U.S. government securities. Once a loan is defeased, the securities portfolio effectively replaces the borrower’s payment stream and makes the remaining mortgage payments on the loan, allowing the borrower to simultaneously either refinance or sell his property free and clear.
However, with the cost to defease tied directly to the cost of U.S. Treasuries (i.e., the higher the cost of Treasuries, the higher the cost to defease), many owners have dismissed defeasance as impractical, especially those with several years remaining until loan maturity. Moody’s reported that 58 percent of loans defeased in 2012 had one year or less remaining on their terms. Since 2008, the cost to defease has ranged from four to six points per year remaining on the loan, leading many borrowers to “sit” on their loans rather than sell or refinance.
Yet while penalties still range from tens of thousands to tens of millions of dollars, many borrowers on self-storage properties can actually save considerable amounts by defeasing today (see the sample analysis below). For borrowers looking to take advantage of today’s lending market, defeasance presents the opportunity to move from 5.5 percent to 7.5 percent rates into 3.5 percent to 4.5 percent rates while protecting themselves against probable interest-rate increases over the next few years. In many cases, defeasing today means negating interest-rate risk at a minimal cost.
For a self-storage borrower with a loan whose original principal balance of $10 million was originated in June 2005 at a 6 percent interest rate, the potential cost savings from defeasing now will be approximately $582,724, based on current interest-rate forecasts. As illustrated, the total cost to defease will be approximately $1 million, while total savings recognized by locking in a new 10-year loan at 4 percent interest rather than 5.5 percent interest will be approximately $1.6 million, resulting in a net profit. Should interest rates move above 5.5 percent, these costs will be even more substantial.