Paying Off a Commercial Real Estate Loan Early Through Defeasance
Defeasance is a strategy that permits the repayment of a commercial real estate loan on a property in order to facilitate the property’s sale or refinance. Many securitized mortgages are packaged to create investment products called commercial mortgage-backed securities (CMBS). Because the stability of these products depends on the guaranteed return of the investment from the interest charged over the original term of the loan, prepayment is generally prohibited.
Defeasance is the replacement of the loan proceeds with government-backed securities such as treasury bonds, that offer the same return. The security offered by the defeasance process must promise enough cash flow to pay the original commercial property loan's interest and principal so that the lender does not end up with less money than if the loan had remained intact.
The result is that the borrower can pay off the commercial mortgage loan early and sell the property without a lien transferred to the buyer. The securities are transferred to a successive borrower, who can make an additional profit off the transaction.
How Do Borrowers and Lenders Benefit from Defeasance?
In general, defeasance can be highly beneficial to borrowers, as it involves the substitution of a riskier asset (a commercial real estate loan) with a much safer asset (typically U.S. Treasury bonds). And, for borrowers, defeasance can be helpful as well, as it allows them to get out of a loan early, freeing up their capital for investment opportunities that may generate a higher yield than their original commercial property.
Borrowers Typically Require Experts to Assist With Defeasance
Since the defeasance process is complex and time-consuming, most borrowers considering defeasance will usually hire a team of defeasance consultants in order to help them complete defeasance with as little hassle as possible. This often includes bond buyers, lawyers, and sometimes even tax experts (fortunately for borrowers, defeasance is tax deductible.) Interestingly enough, defeasance consultants may not always recommend defeasance; depending on the circumstances and going Treasury rates, it may actually be a better choice to avoid prepaying the loan altogether.
Whether defeasance is a good idea also depends on the specific defeasance terms outlined in a borrower’s loan agreement. For example, defeasance is more ideal when a lender allows a borrower to use agency bonds, and less ideal when they need to use Treasury bonds.
Yield Maintenance vs. Defeasance
For CMBS loans and certain other types of commercial mortgages, yield maintenance is the main alternative to defeasance. Yield maintenance permits a lender to gain the same yield that they would if a borrower was not prepaying the loan. In general terms, yield maintenance is repaying a loan early with a penalty covering all future interest, while defeasance is actually substituting the loan’s collateral with another income generating asset. Some CMBS and conduit loans (as well as some other kinds of securitized debts) may actually allow borrowers to choose between yield maintenance or defeasance.
Yield maintenance is generally more favorable to a borrower when Treasury rates are not compounded monthly and payments are calculated to the prepayment date with a lower prepayment penalty (usually 1%). However, if Treasury rates are compounded monthly and payments are calculated to the maturity date (and a higher prepayment penalty, say 3%, is levied), defeasance may be a better idea.
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