Defeasance, in its simplest terms, is the substitution of collateral. In the world of commercial mortgage-backed securities (CMBS), the substitution involves a borrower replacing the real estate securing its a loan with a portfolio of U.S. securities. The portfolio is designed to generate the same debt-service through the term of the loan as the original collateral. This allows the lien on the original collateral to be released.
Sounds simple, right? Well, bad news and good news. The bad news is that the defeasance process is complicated, involving many parties, an involved analysis to determine whether the benefits to the borrower of a defeasance transaction outweigh the process’s significant costs, and the selection of an efficient portfolio of securities.
The good news? Two-fold.
First: This article will give you enough information to understand:
- The reasons why defeasance is used
- The parties who drive the process
- The mechanics of the process, and
- A few items borrowers should consider in the defeasance arena
The second bit of good news? Because the process is so involved, borrowers typically engage specialized consultants whose entire role is to do all the heavy lifting, and allow borrowers to enjoy the benefits of defeasance without understanding much if anything about the process.
So… if you’re still reading this, I guess you didn’t immediately click away to hire one of these consultants, and still want to learn about the process for yourself. Good. Let’s get started.
Why Is Defeasance Used?
When investors buy CMBS, they expect a continuous cash flow, with a specific yield, for a defined period of time. Accordingly, they don’t want a borrower to have the ability to pay the loan off early, even if they were required to make a prepayment penalty, because this ability would disrupt the investor’s expectations.
As noted in an article in the American Bar Association’s “Business Law Today,” borrowers on the other hand want some prepayment flexibility to either: (1) “unlock” equity buildup in the property (such as sale or refinancing with a larger loan), or (2) restructure their debt at a lower cost (such as refinancing at a lower interest rate).
Defeasance allows both parties to get what they want.
CMBS investors are happy because the original note remains in place, and while the collateral has changed from real estate to a portfolio of securities, the portfolio is designed to create the same loan payments as if the original collateral had remained in place. In fact, investors may prefer the new collateral because U.S. securities are less risky than real estate.
Borrowers are happy because with the release of the original lien, they can now sell or refinance their property when the real estate or lending markets dictate that such moves make financial sense.
What Rules Control Defeasance Rights?
A borrower’s right to defease, appoint a successor borrower (part of the process detailed below), what types of securities can be included in the portfolio, and the conditions of defeasance are found in their mortgage or loan documents, which vary from lender to lender. In the absence of such defeasance language, a borrower generally has no right to defease. Here is an example of typical defeasance language.
There are a couple of items a borrower may want to negotiate in their original loan documents in anticipation of a potential need to sell or refinance their property.
Firstly, as noted in an article by the CCIM Institute, borrowers will want to define defeasance collateral in loan documents to include not only U.S. Treasuries but also other agency securities that may have a higher yield. This thought is echoed by Wells Fargo who counsels “borrowers should request that the substitute collateral include other U.S. Government obligations such as Ginnie Mae (Government National Mortgage Association or GNMA) and Sallie Mae securities. These securities typically trade at a higher yield than treasuries, which reduces the cost of purchasing the substitute collateral, effectively reducing the prepay penalty.”
Secondly, borrowers may want the original loan documents to allow for both defeasance and yield maintenance (a form of prepayment discussed below). This is because the financial benefit of a defeasance is tied to interest rates and bond yields, which, of course, fluctuate. In some market conditions, yield maintenance may be more cost-effective.
In addition to the terms of the loan documents, certain IRS provisions bind the holders of most CMBS. The holders are Real Estate Mortgage Investment Conduits (REMICs), and are subject to IRS provisions and U.S. Treasury regulations. As noted in an American Bar Association article, these regulations require that defeasance is only allowed where:
1. The mortgage release cannot occur within two years of the date the loan was securitized. This two-year period is sometimes referred to as the “lockout period.”
2. The loan documents must expressly permit defeasance, and amending loan documents to add a defeasance right is not permitted.
3. The substitute collateral must consist “solely of government securities (as defined in Section 2(a)(16) of the Investment Company Act of 1940 as amended (15 U.S.C. 80a-1)).” The article notes that this has been interpreted as non-callable U.S. government obligations and certain debt obligations of FNMA and FHLMC.
4. The lien can only be released to facilitate property disposition or other customary commercial transaction, not as part of an arrangement to collateralize the REMIC with assets that are not real estate mortgages. A sale or refinance would meet this requirement.
Interestingly, it is not uncommon for lenders who don’t traditionally pool their loans to include defeasance provisions in their loan documents so that they may, if they chose, securitize the loan.
The Defeasance Process
A borrower is considering defeasance. What’s his first step? What happens next? Let’s walk through the process. A process that typically takes 30-45 days to complete (though it will only take you 3 minutes to read this summary).
1. Contact Defeasance Consultant – Is Defeasement Allowed & Appropriate
The easiest way to determine if defeasement is allowed and appropriate for a borrower is to ask someone who works with them every day: a defeasement consultant. The consultant can begin their initial review with as little as a property address. From this they can pull from public records the mortgage encumbering the property and its defeasement provisions. However, it can speed up the process if a borrower can provide all loan documents.
The consultant will consider current the current loan balance, interest rate, amortization term, and dates relating to the loan and proposed defeasement to estimate costs (a “market cost estimate”). Borrowers can also make a rough estimate on their own using a defeasement calculator such as found here.
2. Notice and Deposit
If the borrower and consultant agree that defeasement is the proper solution, borrower notifies its loan servicer of its intent to defease, and gives them a good faith deposit. The deposit will offset some costs incurred by borrower during the process.
Generally borrowers must give at least 60 days notice of the intent to defease, though lenders may agree to may modify timing.
3. Defeasement Consultant’s Role & Players in the Process
The consultant works on behalf of the borrower, and coordinates all of the players in the show, including:
- Borrower
- Loan Servicer
- Securities Intermediary (or custodian)
- Accountant
- Rating Agencies
- Escrow Agent/Title Insurance Company, and
- Attorneys
The cost of these parties, shouldered by the borrower, can run from $50,000 to upwards of $100,000. Thankfully, the cost of the defeasance is tax deductible, so long as the deduction is claimed in the year of the defeasance.
4. Lender Begins Review
Typically the lender will draft the defeasement agreement and forward to it and other documents to the borrower and consultant for signature. They will also ask the borrower to provide documents necessary for the lender’s review.
5. Form Successor Borrower
While the original loan will stay in place, at closing the borrower will be released from its loan obligations, assigning its obligations to a “successor borrower.” The successor borrower is a single purpose entity created to assume the payment responsibilities under the loan and ownership of the substituted collateral.
6. Structure Defeasance Collateral – Securities Portfolio
The defeasance consultant coordinates the design of the securities portfolio. Some consultants hold a competitive auction for borrower’s purchase of the replacement collateral.
7. Accountant’s Review of Defeasement Collateral
Once the portfolio has been designed, a CPA will determine if the securities to be purchased by borrower will generate cash flow sufficient to make the loan payments through the loan’s term.
8. Ratings Agencies Analysis
If the loan’s defeasement provisions require, bond credit rating agencies (e.g., Standard & Poor’s, Moody’s and Fitches) may have to approve the transaction depending on the size of the loan. The approval is called a “no downgrade letter,” and is generally not required for loans less than $20M, or if it exceeds a certain percentage of the pools total collateral.
9. Closing – Purchase Securities, Assign Loan and Defeasement Collateral, Release Lien
At the start of the closing, the borrower agrees to purchase the chosen securities. The next few steps generally then occur simultaneously.
The borrower assigns its rights and obligations under the loan documents, as well as its ownership of the defeasance collateral, to the successor borrower. The lender releases the lien from the original collateral, permitting the borrower to then sell or refinance the property.
Next, the borrower places the proceeds from this sale or refinance in escrow for the purchase of the replacement collateral. If the proceeds aren’t large enough to purchase the necessary securities, then the borrower will make up the difference. The borrower then purchases the securities with the escrowed funds, and assigns the bonds to the successor borrower.
The securities are held in the name of the successor borrower in a restricted account (“defeasement account”) by a “securities intermediary.” The intermediary is the financial institution responsible for making the loan payments from the cash proceeds of the securities.
10. Payment of Residual Value
As a result of “float value” and “prepayment value,” the securities held by the intermediary may generate more money than needed to meet the successor borrower’s payment obligations. This excess is called the “residual value,” and depending on the parties, it may be kept by the successor borrower or shared between it and the original borrower.
The float value is created because there will be short period of time between when income from matured securities is deposited in the defeasement account and when the intermediary makes the loan payments. During this short period of time, this cash will accrue interest.
Prepayment value is created when the loan documents allow for prepayment several months early. The successor borrower can make this prepayment, and save itself the interest cost that would have otherwise been incurred had it made payments through loan maturity.
As the parties will negotiate who may share in residual value, the timing of this sharing is also negotiable. Defeasement consultants may give the borrower at closing the present value of the residual value that will grow in the defeasement account. Other borrowers may not enjoy a share of residual value until the loan is paid off. Other borrowers may get no part of the residual value.
What Is The Difference Between Defeasance And Yield Maintenance?
Defeasance and yield maintenance are used to affect the same result (i.e., release the lien on the original collateral), but are different processes. Unlike defeasance, where the original collateral is replaced and the original loan stays in place, yield maintenance is the prepayment of the original loan. The prepayment consists of (i) the outstanding balance on the original note, and (ii) a penalty.
Yield maintenance transaction costs are dramatically less than those required by a defeasance. There are no accountants, ratings requirements, or security intermediaries (and none of their attorneys). Typically they command only a fee to the loan servicer.
However, because of the potential profits a defeasance may create, yield maintenance may not be the sounder financial decision. A defeasance consultant can consider current interest rates, bond yields, transaction costs, and suggest which method makes more sense.
Conclusion
Easy peasy, right? Well…. maybe not, but as first noted, so long as a borrower engages an experienced defeasement consultant, at least the process can feel easy.
As always, because this article is provided only for your information, and isn’t legal advice, if you have any specific defeasement issues, it’s best to hire a lawyer to answer your questions.
Did we miss anything? Have you been through a defeasement? If you have any questions, comments, or stories, feel free to share them in the section below.