Investment Analysis

Demystifying Defeasance

Securitized debt can seem daunting, but it’s possible to sell or refinance assets.

I give my client a moment to think, and then repeat myself, saying, “The lender's real estate collateral will be replaced with a cocktail of securities, the collective returns of which will mimic the borrower's repayment obligations as if the debt had not been defeased.”

Explaining the process, sequencing, and business considerations of defeasance to anyone new to the world of securitized debt is an interesting experience, because nothing about defeasance is intuitive. Very smart people can have a hard time absorbing the mechanics of defeasing debt and the interplay between the involved parties. Here's my attempt to demystify defeasance.

In traditional commercial real estate lending, the promissory note sits in the bank's safe from the date of closing until the debt is paid off. These are known as balance sheet loans, simply because they stay on the balance sheet of the bank. By comparison, fixed-rate commercial mortgage-backed securities loans and Fannie Mae/Freddie Mac apartment building loans can be securitized. In the world of securitized debt, loans with particular characteristics are bundled together, rated by Standard and Poor's or another credit rating agency, and ultimately sold to a roster of certificate holders (usually exchange-traded funds, pension funds, sovereign wealth funds, and other institutional investors).

It is important to note that certificate holders are “only money” investors who lack the administrative apparatus to service the debt. From the closing date on, a servicer (often an affiliate of a recognizable financial institution) is designated to act for the certificate holders in all respects. Who does the property owner call if there is a fire at the property? The servicer. Who is notified when the property owner wants to put an addition onto their building? The servicer. Who is bound to strictly interpret and follow the terms of the loan documents on behalf of the certificate holders (often to the chagrin of the property owner)? Yup - the servicer.

Why Defeasance? 

There are two primary reasons for a property owner to defease its securitized debt - either to sell the collateral real estate or to refinance. So, why can't the property owner simply prepay the debt as it would with a balance sheet loan? Traditional prepayment is not permitted because certificate holders demand payment and yield certainty on their investment. A conventional prepayment model would disrupt the payment stream flowing to the certificate holders. 

In the right context, defeasing securitized debt can be an intelligent, financially advantageous exercise for a property owner.

So, in the world of securitized debt, the straightforward concept of prepayment is replaced with defeasance, a more complicated, multistep process indicative of the ongoing Wall Streetification of CRE. The best way that I can explain defeasance is to revisit conversations that I've had with clients when I know that they don't really understand.

“What are all these opaque defeasance fees showing up on the draft closing statement?” my client's CFO may ask. “They add up to a lot of money!” 

“Well,” I respond, “have you ever traveled to a developing country? No? Well, after you get off the plane in such a place, you go to the baggage carousel to collect your luggage. When you do, an official-looking man in uniform may stick out his hand and say that you owe a luggage fee of $20 per bag - in U.S. dollars, of course. You roll your eyes and pay him. And he puts your money in his pocket. A few minutes later, at customs, somebody else may demand $100 as an 'entry fee.' The next guy says you must pay a $50 tourism fee and - smiling broadly - he'll keep your passport if you don't pay up. They're all in uniform; they're all part of the 'official' process. You won't enjoy paying them, but that is the cost of visiting that country.” 

Defeasing debt is no different. A battery of servicers, consultants, accountants, and counsel are getting paid to enable you - the property owner - to release the existing mortgage lien on your property so that you can refinance or sell your property.

Spotlighting Sequencing

If you've made it this far, you have a general sense of defeasance. Now, let's go a little deeper into some details. 
In a defeasance context, the property owner is referred to as the “original borrower,” to differentiate from the unaffiliated “successor borrower” who will assume obligations under the existing loan documents from the defeasance closing onward. 

The original borrower is typically forbidden from paying off the mortgage debt for a period of two years following securitization. Once this lockout period ends, the original borrower can trigger defeasance by notifying the servicer of its intent to defease and paying a nonrefundable deposit. The original borrower then needs to retain counsel to represent it and select a defeasance consultant.

Unlike most modern real estate closings, which are planned for a single day, defeasance closings are typically spread over two days.

The servicer's counsel will draft a set of defeasance documents that are standard from deal to deal, but are negotiable in certain key areas. The release that protects the original borrower after the defeasance closes is of particular importance, to be discussed more in a bit. The defeasance documents will also be reviewed by counsel for the successor borrower.

Unlike most modern real estate closings, which are planned for a single day, defeasance closings are typically spread over two days. Once the defeasance documents are finalized and the original borrower is ready to close the refinance or sale of the property (as applicable), the original borrower will give its authorization for the replacement collateral securities to be “circled” (that is, identified and committed to be purchased) on Day 1 of the closing. On Day 2 (the following business day), the original borrower is obligated to purchase the circled securities and close the defeasance transaction. Critically, the lien encumbering the real estate collateral will be released on Day 2, enabling the defeasance closing to be synchronized with the closing of the corresponding refinance or sale of the property. This procedure requires significant coordination among all involved parties and their counsel. 

Sweet Release

After the original borrower refinances or sells their property, the successor borrower assumes obligations with respect to the underlying loan, and the indebtedness due to the lender lives on. This maintains the payment obligations under the existing note, which is of great importance to the certificate holders. To insulate against loan defaults occurring after defeasance, the original borrower negotiates for a release from future claims, liabilities, and obligations related to the underlying loan. This release is embedded within the defeasance documents. 

To the uninitiated, defeasance may seem overwhelming and expensive. However, in the right context, defeasing securitized debt can be an intelligent, financially advantageous exercise for a property owner looking to take advantage of attractive refinancing terms or a high purchase offer. In the end, despite it being a daunting topic to the unfamiliar, defeasance isn't so daunting once you understand the underlying procedures.

Andrew Maguire, Esq.

Andrew Maguire, Esq., is a real estate partner at McCausland Keen + Buckman in the greater Philadelphia area. Contact him at amaguire@mkbattorneys.com.

 

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