Borrowers are often fearful of defeasance, but why? With the recent low interest-rate environment fresh in everyones minds, defeasance has built up a negative connotation among owners and brokersparticularly those associated with self-storage propertieswith 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 borrowers 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. Moodys 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 todays 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.

Moreover, for self-storage borrowers looking to lower their defeasance costs by waiting for U.S. Treasury yields to rise, it should be noted that this strategy will most often have only a minimal impact on costs. For example, should the borrower on our sample loan choose to delay his defeasance until the relevant Treasury rates have risen 10 basis points, his defeasance savings will be only approximately $18,000. Obviously, while these savings are certainly helpful, they pale in comparison to the potentially hundreds of thousands of dollars in increased interest costs that borrowers risk incurring by delaying a refinance.

Indeed, most borrowers view defeasance as a Treasury-rate game, believing they should delay their defeasance as long as possible to lower their costs. However, as the table demonstrates, the rewards associated with defeasing today can often outweigh the rewards of delay.

Self-Storage Defeasance Activity

In 2010 and 2011, defeasance rarely made sense for self-storage owners, as storage properties comprised a mere 6 percent of defeasance activity. However, 2012 saw a significant uptick in self-storage defeasance, as industry properties comprised 16 percent of all defeasances. Current 2013 forecasts project an even greater increase in the number of self-storage properties being defeased, as both market factors and loan terms have pushed borrowers to refinance or sell.

With new fixed-rate loans offered at historic lows, borrowers are incredibly incentivized to refinance as soon as possible. Moreover, with many self-storage loans originated from 2003 to 2005, defeasance costs are reaching manageable levels, allowing borrowers the opportunity to refinance without exorbitant penalties.

Its also likely that the jump in self-storage defeasances over the past year is due to the increasing attractiveness of acquiring self-storage properties and the subsequent increase in property sales. As self-storage capitalization rates have dropped to historic lows, buyers have increasingly turned to defeasance to replace existing debt with new 10-year financing at todays historically low rates.

Eitan Weinstock is the senior defeasance analyst at defeasance firm AST Defeasance Services. For more information, call 866.333.3273; e-mail [email protected] .

Based in Chicago, Shawn Hill is a principal at The BSC Group, where he advises clients on debt and equity financing and loan-workout services for all commercial property types nationwide, with an emphasis on the self-storage asset class.  He can be reached at 312.207.8237; e-mail [email protected] ; visit www.thebscgroup.com .