Choosing a Defeasance Consultant
Borrowers may need help navigating this complicated exit strategy.
With commercial real estate credit markets slowly beginning to thaw, borrowers are beginning to explore the costs and requirements associated with exiting existing real estate debt. If the loan has been sold into a commercial mortgage-backed securitization, borrowers will likely find that their only alternative is to go through the loan defeasance process.
At its most basic level, a defeasance is a substitution of collateral and assignment of debt. The borrower is required to purchase a portfolio of government securities that will produce cash flows matching the debt service schedule of the original loan. This portfolio replaces the real property as collateral for the loan, enabling the borrower to obtain a release of the lien on the real estate property to facilitate a sale or refinance. Simultaneously, a new, or successor, borrower assumes the portfolio of securities as well as the payment obligations of the original loan. While the process sounds relatively straightforward, in actuality it is a complicated procedure involving numerous parties and considerable documentation.
Why Hire a Defeasance Consultant?
Although many borrowers are familiar with the basic process, most still opt to engage a consultant to assist in navigating the financial and legal aspects of the transaction. In addition to bringing clarity and order to an otherwise cumbersome process, a good defeasance consultant will play a key role in reducing the final cost by structuring and coordinating the purchase of an efficient defeasance portfolio and establishing the successor borrower entity in a way that returns a portion of the accumulated interest or residual value back to the original borrower.
Because defeasance is both an economic and legal process, it can take anywhere from three to six weeks to complete. The transaction brings a multitude of people to the table: the original borrower and its counsel, the loan servicer and its counsel, an independent accountant, the securities intermediary, a title and/or escrow agent, the successor borrower and its counsel, rating agencies, and the special servicer. Rather than the borrower and its counsel trying to manage the players and the process, the consultant should serve as a single point of contact for all coordination, including facilitating all conference calls, ensuring that documents and comments are circulated in a timely manner, and making sure that all requirements meet the borrower’s closing timeline.
In addition to overseeing the entire process, the consultant also should be able to structure the portfolio of securities -- typically U.S. Treasuries or agency securities, such as those issued by Fannie Mae or Freddie Mac. This replacement collateral must produce cash flows that match the debt service payments of the original loan, while still adhering to legal and industry standards, as well as making sure the types of securities that can be used to structure the portfolio adhere to the loan document requirements. This task is further complicated by gaps in the issuance of securities as well as the goal of price efficiency. Each servicer interprets the rules and requirements differently and it’s important that the consultant is familiar with the nuances of each servicer’s interpretation.
Once the portfolio has been structured, the defeasance consultant should coordinate the purchase of the securities on behalf of the borrower, ideally by holding a competitive auction. By including several market-maker banks, with each providing simultaneous real-time pricing, the borrower has the best chance of receiving the most efficient pricing possible.
The following example illustrates the importance of the auction process. A borrower needed to defease a CMBS loan with an outstanding balance of $14.7 million and five years remaining until maturity. The securities auction included four banks and resulted in a spread in price levels of more than $110,000 on the cost of the securities.
Cost of Securities
The consultant holding the auction should not have any relationships or affiliations that would impact pricing or result in a undisclosed brokerage fee that would be passed on to the borrower.
Finally, the consultant should also be able to establish the successor borrower, the single-purpose entity that assumes the rights and obligations of the original borrower on the loan. The successor borrower entity should assume all shortfall liability, meaning that if there was a shortage in funds available to make a payment for any reason, the successor borrower would be the entity responsible (not the original borrower). This provision is key for the defeasance to be considered a complete extinguishment of debt for accounting purposes.
Obtaining Defeasance Cost Estimates
Many borrowers often obtain an estimate of the cost to defease by using one of a number of available Web-based calculators. Most calculators provide a general idea of the cost of the substitute collateral as well as third-party fees. It is a good idea to use the results from at least two different calculators to make sure there is not a significant discrepancy in the assumptions made by the consulting firm. Because the market for U.S. Treasuries is very liquid and relatively efficient, the price of the portfolio should not vary significantly from one consultant to another. In much the same way, many of the third party fees are not set by the consultant and should be consistent across the various estimate results. If a borrower finds that one calculator produces results that are much lower than others, then it is best to follow up with a call to determine the source of the inconsistency.
If a borrower is further along in the process and desires a detailed, accurate estimate of potential defeasance costs, it will need to provide the consultant with copies of the primary loan documents such as the promissory note and loan agreement or deed of trust, the property address, and a targeted closing date. With this information, the consultant can tailor the estimate to the specific defeasance terms and servicing requirements of the loan. This is an excellent time for the borrower to ask questions about the process and the consultant’s role, as well as get a feel for the level of service a consultant will provide throughout the transaction. A borrower will be placing a large amount of responsibility in the hands of the consultant, and the initial estimate phase provides a valuable opportunity to determine how responsive and attentive a firm will be.
Interpreting the Estimate
Every defeasance estimate should include three primary components: the cost of the defeasance collateral, third-party fees, and estimated residual value that will be returned to the borrower.
The most significant of these components is the cost of the defeasance portfolio. Ideally the estimate should be based on live market pricing of an actual optimized portfolio, as opposed to a generalized estimation using benchmark Treasury rates. Again, there should not be a significant variance in the estimated portfolio costs from various firms. If a discrepancy exists, it is possible that the estimates they are comparing were not prepared on the same date or at roughly the same time; even slight movements in Treasury rates will have an impact on the cost of the portfolio.
The second item is a comprehensive list of third-party fees a borrower can expect to incur as part of the defeasance, including those of the servicer, servicer’s counsel, certifying accountant, security intermediary, defeasance consultant, successor borrower, and successor borrower’s counsel. Most of these entities operate on a fixed fee schedule, and the consultant has very little if any control over the fees charged by the servicer and their counsel. All of the other third parties are typically selected by the consultant and the fees are usually negotiated by the consulting firm. The consultant should be able to explain these fees and explore whether any discounted fees may be offered.
The final estimate component is the amount of residual value associated with the defeasance and the amount of this value the consultant is willing to return to the original borrower, either at the close of the defeasance or at the maturity of the original loan.
What Is Residual Value?
There are two sources of defeasance residual value: interest income, also referred to as float, and the prepayment of a defeased loan. Interest income will accrue in the defeasance account as a result of timing mismatches between the cash coming into the account from the coupon payments or maturities of the defeasance collateral, and the outgoing debt service payments for the loan. This cash will typically earn interest at money market rates and will accumulate over the life of the defeased loan. The largest portion of this float will come from the balloon payment. For example, if the loan is a $25 million interest only loan that matures on October 26, 2016, the security that would be used for the balloon payment would be the September 30, 2016 bond. The $25 million would sit in the defeasance account for 26 days, earning interest at the current money market rates.
The second source of residual value comes from the prepayment of the defeased loan. The original loan documents will often permit the borrower to prepay the loan at par three to six months prior to the maturity date. However, the documents also usually require that the defeasance collateral provide for payments through the maturity of the loan -- regardless of whether this prepayment window exists. Unless the right to prepay the loan post defeasance is explicitly prohibited, the successor borrower assumes this right when it takes assignment of the debt and the securities. In these instances the successor borrower will pay off the loan and any excess defeasance collateral no longer required is then sold on the open market. The profit gained from the sale of these securities belongs to the successor borrower.
Combined, the float income and value of prepayment can result in a significant amount of residual value. The borrower should make sure the consultant acknowledges this value, provides an estimate of the total value, and finally discusses the amount of this value that will be returned to the original borrower, either on a projected present value basis at the close of the defeasance, or as a percent of the actual amount available in the successor borrower account at the maturity or prepayment of the loan. When comparing estimates, it is important to evaluate not only the percentage of residual value that will be returned, but also the total amount projected. If there is a significant difference in the residual projection, one of the estimates may contain errors or inaccurate assumptions.
If the loan documents allow the lender or loan servicer to set up the successor borrower entity, the consultant may not have control over the residual value and how it will be distributed. They should still be able to predict the amount that will be available so that the borrower can work to negotiate a sharing arrangement directly with the servicer.
The Right Consultant
One of the most important steps in the defeasance process is the selection of the right consultant. By engaging someone to handle the legwork of the defeasance process, the borrower can focus on the real estate portion of their deal, comfortable in the knowledge that they have hired someone who will look out for their best interest, get the best execution possible, and close the deal on time.