- Defeasance is a loan prepayment penalty of sorts and it involves the substitution of collateral.
- If a loan is part of a commercial mortgage backed security, the holder of the security expects a certain stream of cash flows. If the loan is paid off early, that stream is disrupted.
- To replace the stream of cash flows, the borrower must pay a “penalty” in the form of a basket of securities that is constructed to replace the cash lost from the paid off loan.
- The existence of a defeasance provision raises the risk profile of an investment transaction because it can limit a borrower’s flexibility to consider a sale or refinance. It can also result in significant, unexpected transaction costs.
- As an investor, it is not necessary to understand the specific legal language surrounding a defeasance provision in a loan agreement. The important part is knowing that the provision exists and that it can elevate the risk in a transaction through decreased flexibility and increased transaction costs.
Nearly all commercial real estate transactions are financed with some combination of equity and debt. Equity is money that is raised from investors, and debt is a loan that is made by a bank or real estate lender. In return for their loan, the debt holder typically has a first claim on any cash produced by the property, which is used to make the loan payments. They are also first in line to collect any bankruptcy sale proceeds. These last two points are important to understand how defeasance works.
Once a commercial real estate loan has been made, it is not uncommon for a lender to pool many loans together and “securitize” them. This means that they create and sell investment securities that are backed by the cash flow produced by the loan payments. These are known as “commercial mortgage backed securities” or “CMBS” for short, and they are a popular product for many institutional investors.
Now, when an investor purchases one of these securities, he or she expects to earn a certain stream of cash flow. But, if a borrower pays off one of the loans that back the securities, this will create a disruption in the cash flow and cause the investor to earn a return that is different than what was expected. There is a penalty for this, and it is outlined in the loan and/or securities agreements.
This penalty, known as “defeasance”, guarantees that the loan’s payments will continue to be met, even after it is paid off and the lender has released their lien on the underlying property. The exact provisions of the defeasance requirement specify how it must be paid, but in most cases, the “penalty” is paid by creating a basket of securities (usually U.S. Treasury Bonds or other government securities) that produce enough income to make the required loan payments. This way, the security holder continues to receive the cash flow, and the borrower is able to pay off the loan early through sale, refinance, or prepayment.
When Does Defeasance Make Sense?
The issue of whether or not it makes sense to pay the defeasance penalty is one of simple cost/benefit analysis. If the cost of the penalty is less than the potential benefit to be gained, it can make sense.
For example, suppose that a borrower is considering the refinance of the loan on his or her commercial property. Doing so means that the borrower will have to purchase $50,000 in securities to replace the original loan payments. However, the refinance will result in a savings of $1,500 monthly. So, the borrower would be able to recover the $50,000 cost within 33 months. In such a case, it may make sense to pay the defeasance penalty.
Sample Defeasance Language
If defeasance exists in a loan agreement, the exact contractual language can vary widely. But, the language below is fairly representative of something that may be found in a loan contract:
“Subject to certain conditions set forth in the Indenture, the Company at any time may terminate some or all of its obligations under the Securities and the Indenture if the Company deposits with the Trustee money or U.S. Government Obligations for the payment of principal and interest on the Securities to redemption or maturity, as the case may be.”
In a commercial real estate transaction, it is important for investors to be aware of the existence of defeasance and understand the specific language to assess the risk in the transaction.
How Does the Defeasance Process Work?
While the defeasance language can vary, the process is relatively similar, regardless of the lender. In general, there are three steps.
First, the original borrower signs a defeasance note, the amount of which is equal to the current outstanding balance. The terms of the note—such as the maturity date, debt service, and repayment—are the same as the original note. As security for the defeasance note, the borrower pledges a portfolio of securities to the new lender.
At closing, the original note and mortgage are assigned to a new lender, who then assigns the defeasance collateral to a trust.
Next, the original borrower assigns the defeasance note and securities pledge agreement to a successor borrower who then becomes responsible for the debt obligations on the defeasance note.
From the steps above, it can be seen that the process can be incredibly complicated and it is not for the inexperienced. It is possible to hire a defeasance consultant or lawyer to assist with the complexities.
Why Defeasance Raises the Risk Profile of an Investment Transaction
The existence of a defeasance provision in the loan documents is not necessarily a bad thing. But, it is something that investors should be aware of because it raises the risk profile of the transaction in two ways: flexibility and transaction costs.
First, the existence of defeasance limits flexibility in the transaction. For example, a property owner may wish to refinance his or her debt to take advantage of lower interest rates. However, if it is a CMBS loan, there could be a significant prepayment penalty in the form of defeasance, which requires detailed analysis to determine if it is worth it or not.
Second, depending on the location of the property, the existence of defeasance can result in the imposition of significant taxes. For example, a defeasance event for a property located in a state like Maryland, Minnesota, or Florida can trigger significant mortgage recording taxes on the buyers (in a purchase) or on the original borrower (in a refinance).
The Bottom Line
For individual investors who place their money with a commercial real estate transaction sponsor, it is not necessary to know the specific legal language of defeasance. The key is knowing whether or not this provision exists in the loan documents and how the sponsor will manage the cost associated with it upon sale or refinance. It is a good question to ask and an even better piece of information to be aware of.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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