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 cant or doesnt want to assume the loan. In both cases (and any other), its 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 thats 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 borrowers counsels 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.
Structures and Execution
With so many clients transfixed on finding the least expensive third-party transaction costs, the single biggest cost component is the defeasance securities cost. While theres a limited universe of securities eligible for each defeasance, many think defeasance securities portfolios across multiple providers would be the same. Thats not necessarily the case.
The two most important factors for defeasance portfolios are structuring and execution. Great execution means little if you purchase an inefficient structure, while poor execution can also ruin a perfectly efficient portfolio. Many trading desks that structure their own portfolio could have inventory they may want to unload, which may be good for their positions, but would be inefficient for the defeasance and subsequently increase the defeasance costs.
Likewise, an efficient defeasance structure could be submitted to various trading desks for multiple bids, but you could be choosing the best of three bad bids with layers of sales commissions buried in the trades. Defeasance consultants should have extensive experience with portfolio structuring and deep relationships with trustworthy trading desks.
There also are a couple of variations on the standard defeasance that borrowers should understand: the New York-style defeasance and the partial defeasance.
New York-Style Defeasance
The real estate mortgage investment conduit trust (the lender) will assign the existing note and mortgage to the new lender to accommodate the borrower's (or buyer's) desire to reduce mortgage recording taxes on the new loan financing. While the servicer or their counsel may charge an additional fee to accommodate a New York-style defeasance, the savings often is worth the extra effort.
New York is the only state with a concrete ruling from the taxing authority that this structure will not require payment of mortgage tax on the existing debt. As such, nearly all defeasances of New York properties are structured New York-style. Florida is the state where the next highest frequency of New York-style defeasances when the borrower can save on both the documentary stamp and intangible tax. Other high-tax jurisdictions include Kansas, Virginia, Tennessee, Washington D.C. and some counties in Maryland (i.e., Prince George), where recording an indemnity deed of trust is troublesome. Its important borrowers examine the economics of saving on the tax.
Some cross-collateralized loans and single loans secured by multiple properties include an option to defease a portion of the loan related to individual properties. If so, some servicers or their counsel may charge an additional fee for the additional documentation required for a partial defeasance.
Choosing a Defeasance Partner
The defeasance process has a lot of moving parts, and the real estate closing cannot happen without it. Most borrowers engage a defeasance facilitator, like commercial defeasance, to manage the transaction. Doing so saves the borrower time, money and aggravation, and provides peace of mind that the defeasance transaction will not delay the real estate transaction.
For example, while a borrower could use his own broker to structure and purchase the defeasance collateral, his lack of familiarity with the defeasance process, its timing and delivery requirements can delay closing, and the cost to purchase the collateral can be tens of thousands of dollars higher due to structuring inefficiencies and inflated securities prices. If the broker fails to deliver just one security in a portfolio of 50 securities, the defeasance cannot close, which means the sale or refinance closing has to be rescheduled.
Many conduit loans originated between 2004 and 2007 carry fairly attractive interest rates, have a fair amount of term left to maturity, and are good candidates to be assumed when defeasance doesnt make sense. Many properties are often dually marketed with their existing debt or delivered free and clear with defeasance. Each case is different and unique based on property specifics, existing debt and buyer intentions.
Recently, a portfolio of six self-storage properties, all with similar interest rates and terms to maturity, were sold to a public real estate investment trusts. However, due to various internal factors, three properties were defeased to facilitate new refinancing, while the other three existing notes were assumed. Situations like this happen all the time, so its always prudent to have every exit/transaction strategy available for analysis since very few transactions are alike and happen for the same reasons.
With so few exit strategies available for CMBS loans, there are still numerous variables to consider. Every defeasance needs to make fundamental economic sense before considering a sale or refinance. While online calculators, such as DefeaseWithEase.com, can provide a useful preliminary estimate, its important to consult with only the most experienced and knowledgeable defeasance facilitators who understand the details of each and every transaction.
An experienced facilitator can explain the process, structure an efficient securities portfolio, and proactively manage the completion of the various checklist items to meet the borrowers closing schedule. For more specialized types of defeasance transactions, like partial, multi-loan or New York-style defeasances, its even more important to engage an experienced facilitator whose familiarity with lender requirements for such transactions will keep the defeasance on track.
Knowledge, responsiveness and proactive transaction management save valuable time and money, so the borrower, broker and borrowers counsel can focus on the sale or refinancing with complete confidence that the defeasance will close on schedule.
Based in Chicago, Shawn Hill is a principal at The BSC Group, where he provides mortgage brokerage, financial consulting, and loan-workout solutions to self-storage real estate owners nationwide. He can be reached at 312.207.8237; e-mail [email protected] ; visit www.thebscgroup.com .