What is defeasance and why is it so prevalent?Janell Otisfixed-rate, conduit/commercial mortgage-backed securities, HUD
Defeasance is the preferred form of call protection for
fixed-rate conduit/commercial mortgage-backed securities (CMBS)
loans. Nearly every CMBS loan on all property types originated
nationwide since 1998 requires the borrower to defease the loan
before selling or refinancing. Defeasance has become so prevalent
in securitized 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. Put simply, defeasance is a substitution of
collateral. It is not a simple prepayment, but a 30- to 45-day
process that is usually coordinated with a sale or refinance. The
borrower has more flexibility with defeasance because of the
ability to defease loans at par or even at a discount. There is
also a high level of standardization of defeasance provisions.
Typically, the borrower uses proceeds from the sale or refinance to
purchase a portfolio of U.S. government securities that is
sufficient to make all of the remaining debt service 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, and the portfolio of securities are
assigned by the borrower to a successor borrower who makes the
ongoing debt service payments.
Given the recent widening of CMBS spreads and the general
reaction to uncertainty about spreads in the CMBS lending
community, there are not a significant number of loans of any kind
closing at this time. Since defeasances are typically coordinated
with an associated sale or refinance, there may not be many
defeasances closed in the first half of 2008. However, some in the
industry are predicting that if the market settles down in the
coming months, conduit loans, and by association, defeasances, will
be back with a vengeance later in the year as pent up demand is
released. For those who haven't been through a defeasance, the
temporary lull could be used to learn about the defeasance process.
For those that have been through a defeasance, the lull could be
used to gather loan documentation and submit it to a defeasance
consultant for assistance in estimating defeasance costs. If a
second-half rush comes to fruition, those that have used this
market interruption wisely will be prepared to move quickly and
secure the best chance of completing their transaction.
How much does a defeasance cost?
The first step is using an online defeasance calculator. The
defeasance cost is comprised of two components—the securities
cost and the transaction fees. The securities cost is a function of
the spread between the loan coupon and the yield on the securities
on the date the securities are purchased. Generally, if the loan
coupon is higher than the average yield on the securities, there is
a defeasance premium; if the loan coupon is lower than the average
yield on the securities, there is a defeasance discount. Several
loans with interest rates around five percent were defeased last
year. In other words, the cost of the government securities that
served as the defeasance collateral was lower than the outstanding
balance on the loan. That's not always going to be the case, but
defeasance premiums have come down over the last few years as
yields on government securities have crept up.
Engaging a defeasance consultant
Before engaging any defeasance consultant, ask how many defeasances
they have closed, request references, obtain a written cost
estimate and always obtain a written engagement letter. Knowledge,
experience, responsiveness and pro-active transaction management
will save valuable time and money so that the borrower, the broker
and the borrower's counsel can focus on the sale or refinance with
complete confidence that the defeasance will close on
schedule—ahead of any rate lock expiration or sales contract
deadlines.
For those who have not been through a defeasance, it is important
to learn about the process. The first step is for an individual to
gather his loan documentation and submit it to a defeasance
consultant for assistance in estimating defeasance costs well
before his anticipated sale or refinance.
Janell Otis is vice president of marketing at Commercial Defeasance LLC.
She can be reached at (800) 624-4779, or e-mail
[email protected].
