Since 1996, the $300 billion commercial mortgage-backed security
(CMBS) or Conduit market witnessed defeasance become a preferred
alternative to yield maintenance and other prepayment penalties.
As real estate values soar and the availability of cheap capital
remains, real estate professions - as well as borrowers -
must understand the opportunities, as well as the pitfalls,
of loans with the defeasance provision.
In
the CMBS market, defeasance is the process of replacing a
mortgage secured by real estate with a basket of U.S. Government
Securities. The securities purchased pay interest and redeem
the principal in an amount equal to the loan’s monthly
debt service and balloon payment. In essence, the note remains,
but the mortgage is released allowing the borrower to sell
or refinance his property. As a general rule, the smaller
the spread between the loan coupon and the yield on the comparable
maturity treasury, the less expensive the defeasance will
be.
Technically,
a loan with the defeasance provision is prohibited from prepayment
for the entire loan term (unless, of course, the loan is defeased).
Secondary financing is also prohibited, so borrowers who want
to refinance or sell their properties are faced with the complex
task of defeasance.
Defeasance
provisions in loan documents began showing up as early as
1995, but became more widespread with the boom in the conduit
market (1997-1998.) Defeasance came about to help sell the
conduit loans in the secondary market because the buyers of
CMBS bonds prefer defeasance to yield maintenance for various
reasons. 1) It maintains their yields, and 2) it is better
to own Treasuries than mortgages, especially if the yield
is the same.
Moreover,
because the provision helped sell bonds, it also helped reduce
the interest rate the borrower pays. In addition to the reduced
financing costs, defeasance can be cheaper than yield maintenance.
While it is typical in standard yield maintenance for the
borrower to pay at least a 1% prepayment penalty, defeasance
has no such requirement. Should interest rates increase to
a point above the interest rate on the loan, theoretically,
the loan could be paid off at a discount.
Defeasance
also acts as a hedge. If rates go up, the cost of the defeasance
is less, but refinance costs are higher. Conversely, when
rates go down, the defeasance cost is greater, but the refinance
costs are less (what we are experiencing currently.) A lower
refinance cost is advantageous because hopefully, the borrower
is refinancing for more money than the current loan and for
a longer term.
Borrowers
currently have an excellent opportunity to refinance loans
originated between 1996 and 1998. Most likely those loans
represent substantial appreciation, and the currently low
refinance rates make them prime candidates for pulling out
equity. If you think your property is a candidate for refinancing,
you can get an estimated defeasance cost online at www.defeasewithease.com.
As
an additional service, Commercial Defeasance, LLC makes available,
without charge, online defeasance calculators for those interested
in including a calculator on their web site. Interested parties
can call Commercial Defeasance, LLC at 1 (704) 248-2601. The
online calculator will give security costs as well as transaction
costs. In addition, if the loan is not still locked out, the
borrower can make future projections on interest rates so
a sensitivity analysis can be performed.
Once
a borrower has decided to proceed with the transaction, he
and his counsel must be very aware that the defeasance is
a complicated process and, in fact, usually involves more
parties than the refinance or sales transaction. Because of
the complexity, a borrower typically engages a defeasance
consultant. Even the largest investment banks and REITs use
defeasance consultants to assist in the process.
The
role of the defeasance consultant is to take the lead on the
defeasance transaction and work with borrower’s counsel
for the benefit of the borrower. The consultant must be knowledgeable
about the securities as well as the legal and structural issues.
For example, most defeasance transactions fall under New York
jurisdiction and require New York perfection and enforceability
opinions. A good consultant knows this and will have developed
relationships with several New York law firms to provide the
opinions at a reduced rate. The importance of a defeasance
consultant who completely understands the process and the
legal documents will mean the difference between saving on
transaction fees and a delayed closing with unnecessary additional
cost.
In
addition to transaction management, the defeasance consultant
provides significant savings to the borrower in the optimization
and bidding of the Government Securities. The greatest cost
in a defeasance is the purchase of the securities used as
the defeasance collateral. Unfortunately, without a consultant,
borrowers typically pay too much for the securities. Because
a defeasance portfolio consists of multiple securities, the
borrower will pay the cost, plus some mark-up, although the
mark-up is nearly impossible to calculate without knowing
where each security was purchased. (Information rarely available
unless one has access to all the trading systems and knows
where the trades are.)
Our
firm has seen a $35,000 mark-up on a $2 million purchase of
securities. We accomplished the same purchase through another
broker dealer for $3,500. On this transaction, the borrower
paid us $10,000 to act as a consultant, but we saved him over
$30,000 on the securities alone. Because most borrowers do
not normally purchase Government Securities on a daily basis,
they will never get the cost savings (reduced mark-up) that
a consultant can provide.
Our
company takes the position that the consultant’s fees
should be a set fee and not a mark-up of the securities. In
this way, the borrower knows exactly what he has paid for
the securities.
In
today’s market, defeasance has become an attractive
alternative for borrowers wishing to refinance or sell their
real estate assets. Borrowers must be aware, however, that
defeasance is a highly technical and complicated process involving
the coordination of twenty-plus different parties including
rating agencies, trustees, servicers and securities intermediaries
in addition to specialty legal and accounting professionals.
For a relatively small fee, a prudent borrower will engage
a defeasance consultant to manage the transaction on his behalf.
A professional defeasance consultant can save the borrower
potentially tens, of thousands of dollars - not to mention
many hours and the inevitable stress of the complex, time-sensitive
defeasance process.
Article
written by Rob Finlay
Rob
Finlay is managing principal, Commercial Defeasance, LLC in
Charlotte, N.C.
Defeasance
Calculator http://www.defeasewithease.com
NOTE: -Defeasance is not cost effective on smaller loans when it is known or planned to defease the loan. Yield Maintenance is cheaper or Capped Pre-Payment.
Yield Maintenance
Yield Maintenance is a make whole provision found in many conduit mortgage loan documents. The purpose of this provision is to protect the bond holders assuring the flow of interest payments should the note payoff before maturity making the lender whole. For example, let's assume a 15-year interest-only $1,000,000 mortgage at 7%. After the 5th year the borrower decides to refinance. The yield maintenance prepayment penalty would equal the difference between the current 7% rate and the yield that the bank would receive reinvesting the loan proceeds in a 10 year Treasury Note. (10 years being the remaining term of the loan).
To keep this example simple, let's say that at the time of prepayment, the 10 year Treasury note is 5%. The borrower would be required to pay the lender the present value of the 2% difference for each year over the loan's ten remaining years, or $200,000. This penalty will make the lender "whole" and insure that the lender will not experience an economic loss as a result of being paid prior to the loan's maturity. This same formula applies to amortizing loans, however it is much easier to illustrate with an interest-only loan.
Each lender will have a slight variation to this formula, however the above example conveys the spirit of the yield maintenance penalty. Before deciding on Yield Maintenance over Treasury Defeasance; there is another calculation to consider. The CMBS (Commercial Mortgage Backed Securities) Market prices Yield Maintenance loans 10 basis points to the worse over treasury defeasance. Therefore, if you have been quoted on a conduit mortgage, it is assumed be lenders that you want the lowest rate which is treasury defeasance. If you decide on Yield Maintenance, add .10% to your final rate. To determine a yield maintenance pre-payment obligation, click on this hyperlink Yield Maintenance Calculator .
Lock Outs
A lock out can be the most expensive of all pre-payment penalties. Lockouts are a requirement of an obligation to pay the full scheduled interest for a period of time in the loan term such as 60 months. Therefore, should the note be retired within the lockout period as defined in the mortgage documents, the scheduled interest under the terms of the note would be added to the principal balance for a period of time remaining in the lockout. One benefit of lockouts are no administration costs should you elect to retire the note and the remaining obligation can be calculated easily. With a lockout, the lenders are assured of not taking a bath on early retirement of a note on the secondary market. Lockouts are associated with loans that are both very competitive in rate and loans that are risky and not of institutional quality. Lockouts are generally followed by a capped structured prepayment penalty immediately after the lockout period until all prepayment penalties expire.
Capped Pre-Payment Penalties
Capped Pre-Payment Penalties are common on bank loans and secondary market loans. They are structured as follows: 5%,5%,4%,4%,3%,3%, 2%,2%,1%, 0%. Each percentage between the commas represents one year. The obligation or penalty is calculated on the remaining unpaid balance.
Final Comments
All of these prepayment types DO NOT PERMIT acceleration of the note during the pre-payment period by paying extra principal. Prepayment penalties structured in the loan term on 10 year products, allow a period of 3-6 Month in the final months of loan term to secure other financing without obligation of a penalty. Prepayment penalties drive the lower rates and fees on commercial loans. Without them, lenders will take a defense position with upfront loan administration fees, points and higher rates to offset risk of early payoff. Banks may only provide financing for 5 years without a prepayment penalty or incorporate a callable provision to further alleviate exposure to long term risk.
