Defeasance of Commercial Mortgage Loans
Defeasance of a Securitized Commercial Mortgage Loan
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. Generally, a basket of United States treasury obligations is the only collateral “acceptable” for this type of substitution – although some securitized loan documents do allow for the use of agency securities that are less costly. A quick way to get an estimate of the cost of a defeasance is to use a defeasance cost calculator. The original note remains in place after a defeasance, but it is collateralized and serviced by the substituted securities instead of the real estate. These securities can be held by either the original borrower or by a “successor borrower” entity which uses the income from/disposition of the securities to make the monthly debt service payments and balloon payment on the mortgage being defeased. The premium a borrower pays to defease (what some refer to incorrectly as a “penalty”) is the total cost of purchasing the securities less the outstanding balance on the loan. Payments to Commercial mortgage-backed security bondholders are not disrupted, and the borrower can sell or place a new first lien on the property. Unlike yield maintenance, defeasance is neither a type of prepayment nor a prepayment penalty.
This type of defeasance is a relatively new methodology. Looking back to the mid-1990s, it was unheard of to defease a securitized commercial mortgage. Securitized lenders (colloquially known as “conduits”) focused primarily on the securitization of residential mortgages, while commercial mortgage debt was still the bastion of large life insurance companies and commercial banks. But times quickly changed, and at the end of 1996, there was an explosion in the demand for call-protected bonds backed by commercial real estate. This demand helped make conduit mortgage pricing on commercial mortgages more competitive than ever, and in 1997, almost $45 billion in Commercial Mortgage Backed Securities (CMBS) were issued, followed by $80 billion in 1998. While this drastic upward swing was somewhat of an anomaly, it illustrated the quantity of bargain priced “conduit money” that became available in the industry to finance commercial real estate. With that shift came a change in borrower’s attitudes toward conduits, when commercial property owners realized that securitization allowed risk to be allocated more efficiently (translating into lower costs of capital for borrowers). This trend has persisted in the industry. In 2004, roughly 40% of commercial real estate debt issuance (around $91 billion) was financed through the issuance of CMBS. Typically borrowers will hire a defeasance consultant to assist with the defeasance process.
Defeasance Terms to Consider at Loan Origination
- Avoiding Long Lockout Periods
Frequently, the first thing many borrowers notice in loan documents is a provision related to the earliest date — the lockout expiration date — that borrowers can defease the loan. Regulations mandate that securitized loans cannot be defeased until two years after the date of securitization. The period from origination to the date two years later is called the REMIC prohibition period. A defeasance provision in loan documents should allow borrowers to defease upon the expiration of this period. The lockout expiration date is the date a securitized loan first becomes eligible for defeasance. To ensure borrowers have the greatest flexibility in timing defeasance, it is important that the lockout expiration date immediately follows expiration of the REMIC prohibition period.
- Defeasing to the Prepayment Date vs. the Maturity Date
Borrowers may have the option of prepaying a loan anytime from one month to six months before maturity of a loan without penalty or premium. The date on which borrowers may prepay the loan is the prepayment date, and the period from the prepayment date to maturity is called the prepayment period or open period. A defeasance provision typically requires borrowers to purchase substitute collateral that provides for payments from the date of defeasance through the maturity date, without regard to whether a prepayment right exists in loan documents.
In some cases, borrowers are allowed to purchase defeasance collateral to provide for payments through the start of the open period, possibly realizing securities portfolio cost savings equal to the present value of those final months' interest payments. However, purchasing defeasance collateral that provides for payments up to the start of the open period can sometimes (though rarely)be more expensive than purchasing defeasance collateral that provides for payments through any payment date within the open period. This scenario, typical for loans with several years remaining to maturity, is true if, at the time of defeasance, a U.S. government agency has not yet issued securities that will mature in time to cover the final loan payment on or close to the desired balloon payment date.
- Maximizing the Benefits of Prepayment Rights
If borrowers must defease to the maturity date and cannot have the flexibility of purchasing defeasance collateral portfolios that make a final payment before the maturity date, loan documents should provide that any right to prepay the loan should survive the defeasance. Eliminate any loan document provisions that preclude the right to prepay the loan after a defeasance has occurred.
In many instances, the ability to prepay loans is especially valuable in the context of a defeasance if borrowers have the right to set up the successor borrower or to designate what entities will act as the successor borrowers upon defeasance. If borrowers have prepayment rights and can designate successor borrowers, they may be able to enter into an arrangement with successor borrowers’ parent companies whereby borrowers have a right to a portion of the proceeds that successor borrowers receive if and when they prepay the loan. In this case, the original borrowers will realize all or a portion of the savings from the loan interest that otherwise would have accrued for the remaining months.
- Providing Defeasance Deposit vs. Defeasance Collateral
A defeasance deposit is the amount of money required to purchase the defeasance collateral portfolio that provides for monthly payments through the remaining life of the defeased loan. Some loan documents provide that borrowers must deliver defeasance deposits — not actual defeasance collateral — to lenders. If borrowers are required to deliver defeasance deposits, lenders have a right to play a role in various aspects of selecting the defeasance collateral including the structure and purchase of the portfolio. This right can result in potential embedded costs and inefficient pricing.
Conversely, if the defeasance provisions allow borrowers to provide the actual defeasance collateral to lenders and do not require defeasance deposits, the borrowers’ defeasance consultant will be able to structure an optimized securities portfolio and hold a competitive auction to ensure best pricing.
- Agencies vs. Treasuries as Defeasance Collateral
Perhaps the one provision that has the greatest impact on the overall cost of a defeasance is the type of securities that can serve as defeasance collateral. Generic language such as “U.S. obligations” or “government securities” limit these securities to direct U.S. government obligations such as bills, notes, and separate trading of registered interest and principal of securities, also called STRIPS. Though this type of portfolio is not fundamentally detrimental to the borrower, broadening the universe of possible securities will usually result in a more cost-effective portfolio.
Agencies of the U.S. government, or government sponsored entities — including the Federal National Mortgage Association, or Fannie Mae, and the Federal Home Loan Mortgage Corp., or Freddie Mac — issue fixed-rate bonds that typically offer higher yields. These agency bonds also lend more liquidity to the universe of available securities. Because higher yields mean lower prices and increased liquidity creates greater efficiencies, using agency bonds will usually result in a cheaper securities portfolio. With larger transactions, such as those greater than $50 million, government agencies may even be able to structure a customized bond where the cash flows on the bond identically match the payments required on the defeased loan.
- Selecting the Successor Borrower
Loan documents typically require that successor borrowers take the place of original borrowers upon defeasance. Successor borrowers are the entities that will assume responsibility for all payments remaining on loans after they are defeased, thereby releasing original borrowers from any financial obligations under the loan. It is most advantageous for borrowers to have the right to designate what entities will act as successor borrowers. If a defeasance provision gives lenders the right to form or designate successor borrowers, the borrowers may lose the opportunity to potentially benefit from residual value created by portfolio inefficiencies.
Unless a custom security is structured so that payments exactly match principal and interest payments due on the loan, a portfolio of defeasance collateral will have some inherent inefficiency. These inefficiencies are a result of mismatches in timing between cash receipts from the defeasance collateral — coupon payments or bond maturities — and the monthly payments of principal and interest due. The mismatches accrue interest at money market rates over the life of the defeased loan. Custom securities are not available in many cases and though defeasance collateral portfolios can be structured for high efficiency, some residual value is likely to accrue.
Rules governing the structuring of the defeasance collateral stipulate that the earned interest cannot be applied toward scheduled loan payments. However, all accrued interest can be realized when the loan matures. If successor borrowers offer a sharing arrangement, borrowers can receive a portion of this residual value. For this reason, it is important for borrowers to be able to designate successor borrowers. As previously mentioned, this tactic also enables borrowers to benefit if the right to prepay the loan survives the defeasance.
Selecting a Defeasance Consultant
- The Role of the Defeasance Consultant
With so many parties and dependencies involved, it would be easy for this process to become delayed. One of the defeasance consultant’s main objectives is to assist the borrower with the necessary steps in order to complete the transaction in a timely manner, allowing the borrower to meet its target refinance or sale closing date. The defeasance consultant should be expected to facilitate conference calls, ensure documents and comments are distributed in a prompt fashion, and assist and coordinate the delivery of documents to reviewing rating agencies. While certainly less complex than some of the other functions a consultant provides, the orchestration of the defeasance is a very necessary role.
In addition to ensuring the process runs smoothly, the defeasance consultant is also responsible for structuring the defeasance portfolio. This portfolio of optimized securities–-typically US Treasuries or Agency securities–-will match the debt service payments of the original loan while still adhering to legal and industry standards. Strict guidelines govern how much cash may be included, month-end balances have limits throughout the life of the loan, and a large universe of bonds exists from which to construct the portfolio. This is further complicated by gaps in the issuance of securities as well as the goal of price efficiency. By and large, the defeasance consultant may contact several sources for the securities on behalf of the borrower.
In most cases, the consultant will also establish the successor borrower entity. This entity will hold title to the defeasance collateral for the balance of the loan term and be responsible for making the remaining debt service payments. Both the borrower’s ability to designate the successor borrower entity and the type of securities permitted as defeasance collateral will be governed by the original loan documents.
How does the borrower choose a defeasance consultant? Knowing the right questions to ask provides a borrower with a framework for evaluation:
- What are the costs?
There are two main cost components the borrower is responsible for when defeasing a loan. The first, and most significant, is the cost of the defeasance portfolio. The market for US Treasurys is very liquid and very efficient, but the actual price of the collateral will vary until they are purchased in closing.
The second cost component is the third party fees incurred during the defeasance process. These fees include payments to the securities intermediary and certifying accountant as well as the fees generated by counsel to the Servicer and the successor borrower. Because defeasance has become a relatively standard process, these fees are generally non-negotiable but the consultant will be able to articulate the reason behind the numbers and explore discounting possibilities (say, due to a multi-loan defeasance).
- What is the residual value of the defeased loan?
An optimized portfolio of securities will match the original debt service schedule of the loan as closely as possible, but there will always be differences in the timing between cash receipts from the defeasance collateral (coupon payments or bond maturities) and cash payments (loan obligations). These mismatches accumulate interest at money market rates and are held in the successor borrower account. Generally, the most significant mismatch occurs between the maturity date of the loan and the Treasury that matures closest, but prior to, that date. Due to the regulations surrounding the defeasance process, this “residual value” cannot be considered at the time the portfolio is built to reduce the portfolio cost nor can it be accessed until the loan has matured. What happens to this residual value at maturity?
Once the loan has been defeased, the successor borrower assumes the obligations of making the monthly payments and the right to the residual value belongs solely to that entity. However, at the time of defeasance many consultants will enter into a sharing arrangement with the original borrower where the consultant will return a portion of the residual value to the borrower upon the loan’s maturity, or offer the present value of the residual value at defeasance closing. This arrangement will enable the borrower to recover some of the costs incurred at the time the loan was defeased. Defeasance consultants can detail tax and accounting implications associated with sharing arrangements.
Another source of significant financial value centers on whether the defeased loan is prepaid. Many loans have a 3-6 month window allowing for the prepayment of the loan without incurring any penalty. However, regardless of whether a prepayment period exists, the defeasance collateral structure must typically make all the loan payments up to and including the payment due on the maturity date. If not explicitly prohibited, the successor borrower may have the right to prepay the loan and sell the existing (unused) securities on the open market. Any profit gained by selling the securities increases the residual value, and accordingly the amount shared back with the original borrower should a sharing agreement be in place.
Once the defeasance process is understood, several competing interests become apparent. The most efficient and therefore least expensive defeasance portfolio is in the best interest of the original borrower. In contrast, the successor borrower benefits from a less efficient portfolio which generates a greater amount of residual value. The defeasance consultant can have an impact on both the creation of the portfolio and benefit from the end result. Knowing how the process works, the correct questions to ask, and the potential conflicts that may exist will allow the borrower to select a defeasance consultant that best suits their needs.