Defeasance for CMBS Loans
Most CMBS borrowers wanting to prepay must go through a process known as defeasance — a process that involves replacing the collateral and interest income that the lender will lose as a result of prepayment with alternative securities, often U.S. Treasury bonds.
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CMBS Loans and Defeasance
CMBS loans are often known for their strict prepayment penalties — so much so that many borrowers consider that to be one of CMBS financing’s major downsides. Most CMBS borrowers wanting to prepay must go through a process known as defeasance. This process involves replacing the collateral and interest income that the lender will lose as a result of prepayment with alternative securities, often U.S. Treasury bonds. Defeasance is widely regarded as a complicated process, though the exact details of each defeasance transaction are typically detailed in the borrower’s loan agreement.
How the Defeasance Process Works
In order to conduct defeasance properly, borrowers often require a team including one or more lawyers, accountants, brokers, and financial advisors. In some cases, investors retain defeasance consulting companies who help clients maneuver through the process and minimize costs. Borrowers may also want to work with an experienced broker-dealer who is able to tailor a pool of securities that can generate sufficient cash flow to cover all remaining payments on the loan through maturity. Additionally, a securities intermediary will be needed — this entity is needed to hold the bonds in a separate account, similar to escrow, in the borrower’s name but for the lender’s benefit. The intermediary’s job includes making monthly debt payments to the lender with the cash proceeds from the securities.
Although the actual defeasance process is relatively standard, every loan is different and can contain attributes savvy consultants can utilize for the benefit of their clients. The portfolio of optimized securities — typically U.S. Treasury securities — will match the value of the remaining debt service payments towards the commercial loan. The pool must also adhere to legal and industry standards. Strict guidelines are in place to govern how much cash may be included as well as setting limits on month-end balances throughout the life of the loan.
Timing Defeasance
Despite the somewhat negative attitude of the industry surrounding it, defeasance can actually work out as the preferred option across many different market environments. This is sometimes seen when interest rates begin to decline — typically leading to an influx of refinancing opportunities. Of course, defeasance can be quite popular during times of high interest rates — at least when there are investors who have sufficient equity in their property to cover the cost of the prepayment penalty.
Defeasance, when utilized strategically, can save investors a considerable amount. In fact, it actually presents investors with a solid exit in a rising-interest market. You see, when interest rates rise, treasury bonds typically lose value — which lowers their cost. This enables investors to purchase the required bonds for much less than what would be required to prepay the loan, which leads to substantial savings. Even when interest rates are falling, the cost to an investor may not be much worse than what they would be required to cover through yield maintenance.
Avoiding Defeasance on a CMBS Loan
Since defeasance can be a costly way to prepay a loan depending on the market environment, many conduit loan borrowers are hesitant to execute. In those situations, some investors may find it’s less stressful and sometimes even more efficient to simply find a buyer who can assume the loan. One of the best traits of CMBS financing is that the vast majority of conduit loans are fully assumable with a small fee. Technically, as long as the original investor can find a new, qualified borrower for the loan, they can cut ties with the property without conducting defeasance.
Related Questions
What is the process of defeasance for CMBS loans?
In order to conduct defeasance properly, borrowers often require a team including one or more lawyers, accountants, brokers, and financial advisors. In some cases, investors retain defeasance consulting companies who help clients maneuver through the process and minimize costs. Borrowers may also want to work with an experienced broker-dealer who is able to tailor a pool of securities that can generate sufficient cash flow to cover all remaining payments on the loan through maturity. Additionally, a securities intermediary will be needed — this entity is needed to hold the bonds in a separate account, similar to escrow, in the borrower’s name but for the lender’s benefit. The intermediary’s job includes making monthly debt payments to the lender with the cash proceeds from the securities.
The portfolio of optimized securities — typically U.S. Treasury securities — will match the value of the remaining debt service payments towards the commercial loan. The pool must also adhere to legal and industry standards. Strict guidelines are in place to govern how much cash may be included as well as setting limits on month-end balances throughout the life of the loan.
What are the benefits of defeasance for CMBS loans?
Defeasance can be a cost-effective way to prepay a loan depending on the market environment. It can be beneficial when interest rates are rising, as treasury bonds typically lose value, which lowers their cost. This enables investors to purchase the required bonds for much less than what would be required to prepay the loan, leading to substantial savings. Even when interest rates are falling, the cost to an investor may not be much worse than what they would be required to cover through yield maintenance.
What are the risks associated with defeasance for CMBS loans?
The main risk associated with defeasance for CMBS loans is the cost. Depending on the market environment, defeasance can be a costly way to prepay a loan. Additionally, when interest rates rise, treasury bonds typically lose value, which can lead to higher costs for investors. Lastly, defeasance may not be the most efficient option when interest rates are falling, as the cost to an investor may not be much worse than what they would be required to cover through yield maintenance.
What are the costs associated with defeasance for CMBS loans?
The cost of defeasance can vary depending on the market environment and the exact nature of the defeasance stipulations in the borrower’s loan agreement. When interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance will exceed the loan’s remaining balance. However, if current interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance will actually be less than the remaining balance of the loan. In this situation, defeasance can actually save a borrower money, at least in theory.
However, since borrowers will typically have to pay for the services of several consultants, such as broker-dealers, lawyers, and accountants, defeasance rarely saves borrowers money in practice. In fact, the services of these experts often ends up costing between 10% and 30% of the entire loan balance, which can make defeasance a somewhat expensive process.
What are the alternatives to defeasance for CMBS loans?
The best alternative to defeasance for CMBS loans is to find a buyer who can assume the loan. This is possible since the vast majority of conduit loans are fully assumable with a small fee. This can be a less stressful and sometimes even more efficient way to prepay a loan depending on the market environment.
Another alternative is to strategically utilize defeasance when interest rates begin to decline. This can lead to an influx of refinancing opportunities and can save investors a considerable amount. Even when interest rates are falling, the cost to an investor may not be much worse than what they would be required to cover through yield maintenance.