Defeasing CMBS Loans
Low interest rates fuel loan prepayments.
With the real estate
market on a significant upswing and lenders across the U.S. loosening their
purse strings, defeasance activity has picked up substantially over the past
two years. According to industry reports, more than $13.2 billion of commercial
mortgage backed securities loans were defeased in 2013, representing a 123
percent increase from the previous year.
With Treasury yields
keeping defeasance costs relatively high, defeasance activity has been driven
primarily by borrowers looking to capitalize on the current low interest rate
environment and the improved lending arena in general, both for purchases and
refinances. A major impetus behind defeasance is an increase in property value.
The defeasance process allows borrowers to extract equity out of their
properties and lock in new, long-term financing. With property values rising
and sales activity increasing, the result is that more loans are becoming
attractive to defease.
Considering the high
volume of loans nearing maturity over the next few years, the already booming
defeasance industry is expected to be exceedingly active, with Trepp projecting
a significant increase in 2014 defeasance volume over 2013.
The majority of loans
defeased in 2013 were retail, office, and multifamily properties, accounting
for 82 percent of total activity. Similarly, for the first half of 2014, retail
and multifamily properties led the way as the most commonly defeased loans by
asset type, followed by office, hospitality, and self-storage properties,
according to AST Defeasance consultants. Moreover, the short-term trends of the
last few years are changing with 2013 data from Moody’s showing that borrowers are defeasing loans with
longer remaining terms than in 2012.
Despite the rebound in defeasance
transactions over the past two years, defeasance remains an unfamiliar topic to
many professionals in the commercial real estate and finance arenas. Most often
used in commercial real estate as the prepayment penalty on conduit/CMBS loans,
defeasance is the process of releasing a commercial property from the lien of
the mortgage and replacing it with a portfolio of U.S. government securities.
Once a loan is defeased, the securities portfolio effectively replaces the
payment stream and makes the remaining mortgage payments on the loan, allowing
the borrower to either refinance or sell the property free and clear.
The process of defeasance
is highly coordinated and involves an array of professionals, including
accountants, attorneys, brokers, consultants, rating agency personnel, and
trustees. Defeasance consulting firms have become a standard component to
defeasance transactions, retained by borrowers to help maneuver the process and
While the defeasance process itself is relatively
standard, each loan contains unique attributes that consultants maximize to the
benefit of their clients. In addition to ensuring the process runs smoothly,
the defeasance consultant is also responsible for structuring the defeasance
portfolio. This portfolio of optimized securities, typically U.S. Treasurys or
Agency securities, will match the debt service payments of the original loan
while still adhering to legal and industry standards. Strict guidelines govern
how much cash may be included, month-end balances have limits throughout the
life of the loan, and a large universe of bonds exists from which to construct
Defeasance can be a
preferred option in many different market environments, the most obvious being
when interest rates are falling and borrowers can obtain lower interest rate
loans on their properties by refinancing. However, defeasance can also make
sense in a higher interest rate environment when borrowers have enough equity
in their properties to cover the prepayment penalty.
While penalties still
range from tens of thousands to tens of millions of dollars, many borrowers can
save considerable amounts by defeasing in today’s lending market. Defeasance presents the
opportunity to move interest rates from 5.5–7.5 percent to 3.5–4.5 percent,
while offering protection against probable interest rate increases over the
next few years. In many cases, defeasing today means negating interest rate
risk at a minimal cost.
For example, for a
borrower with an original principal loan balance of $10,000,000 originated in
June 2007 at a 6 percent interest rate with a 10-year term, the potential cost
savings from defeasing now will be approximately $562,094.63, based on current
interest rate forecasts. As illustrated in the graphic below, while the total
cost to defease today is approximately $1,040,000, total interest payment
savings from locking in a new 10-year loan at 4 percent interest today rather
than 5.5 percent interest in 2017 will be approximately $1,600,000, resulting
in a net profit of approximately $560,000. Should interest rates move above 5.5
percent by 2017, these savings will be even more substantial.
Moreover, for borrowers
looking to lower their defeasance costs by waiting for yields on Treasurys to rise,
it should be noted that this strategy will most often have only a minimal
impact on costs. For example, should the borrower choose to delay defeasance
until the relevant Treasury rates increase by 10 basis points, the defeasance
savings will be only approximately $21,000. Obviously, while these savings are
certainly helpful, they pale in comparison to the potentially hundreds of
thousands of dollars in increased interest costs that borrowers risk incurring
by delaying their refinance.
Indeed, most borrowers
view defeasance as a Treasury-rate game, believing that they should delay their
defeasance as long as possible to lower their costs. However, as demonstrated
by the savings in the graphic below, the rewards associated with defeasing
today can often outweigh the rewards of delay.
Eitan Weinstock is the
senior defeasance analyst at AST Defeasance in Los Angeles. Contact him email@example.com.