Financing

Demystifying Defeasance

What role does this financing strategy play in today’s market?

The credit markets are frozen and conduit lenders are not lending, but defeasance transactions are still closing. At the end of 2007, more than 36 percent of all outstanding commercial and multifamily loans were securitized — $913 billion of the $3.3 trillion outstanding, according to the Federal Reserve’s Flow of Funds. Chances are good that if a borrower is looking to purchase, sell, or refinance a property, it is encumbered by defeasance provisions.

Starting in the mid-1990s, defeasance became the exit strategy of choice for conduit lenders, thus making it virtually the only alternative for borrowers who wish to exit their fixed-rate, securitized real estate mortgages. A standard defeasance results in the release of the existing mortgage’s lien. Yet, in states that impose a substantive mortgage recording tax — measured by the principal debt or obligations — a defeasance becomes even more punitive for borrowers who wish to refinance their original loans. If the encumbered property is located in such a state, borrowers may elect to execute a new note defeasance in lieu of a standard defeasance in order to realize some savings on this recording tax. Both standard and new note defeasances allow original borrowers to exit their financing by substituting the encumbered real estate with a portfolio of securities as loan collateral. However, new note defeasances contain some structural differences and involve additional parties during the process. Understanding these differences helps borrowers and their attorneys better navigate the defeasance process, and ultimately, save money.

Understanding Defeasance

Conduit mortgage loans are pooled (or securitized) into real estate mortgage investment conduit trusts. These REMIC trusts then sell certificates, also known as commercial mortgage-backed securities, to investors who expect a steady cash flow stream from their investment. If a borrower prepays a loan, this cash flow is disrupted. A defeasance guarantees that the loan payments will continue to be met, even after the property is released.

Defeasance transactions generally close within 20 to 35 days from start to finish, but they can be completed in as little as a week if a borrower is on a tight schedule. Both an economic (maintaining cash flows to CMBS bondholders) and legal (substitution of collateral and substitution of the borrower) procedure, defeasance involves numerous parties, each with different roles and objectives. (See “Defeasance Who’s Who.”)

Defeasance provisions in the underlying mortgages are advantageous to both borrowers and certificate holders. Defeasance provisions give borrowers the ability to unencumber the underlying real estate in order to sell or refinance the property. When a loan is defeased the borrower substitutes the existing collateral with a portfolio of U.S. securities, typically Treasury obligations, structured to match the debt service schedule of the loan through the maturity date. This substitution facilitates the removal of the existing lien on the borrower’s property. The loan remains in place and, as a result of this transaction, the defeasance portfolio provides the CMBS bondholders with the same future cash flows they would have received if the loan was never defeased.

New Note Defeasance

Defeasance transactions are not identical nationwide. For properties in certain locations, including Washington, D.C., Maryland, Minnesota, New York, Florida, and Virginia, standard defeasance events trigger the imposition of significant mortgage recording tax on buyers, or in the case of refinances, the original borrowers.

In 2000, in an effort to mitigate the exorbitant tax costs associated with standard defeasances, New York became the only state to officially address these concerns with the publication of the New York Department of Taxation & Finance’s Advisory Opinion No. TSB-A-00(1)R, which allows borrowers to structure a new note defeasance. The Advisory Opinion confirmed that a mortgage recording tax would not be imposed if the REMIC trust assigned the original loan to the new lender in exchange for a defeasance note and pledge and security agreement. This became known as the “New York style” or “new note” defeasance. While New York is the only state that has expressly stated that new note defeasances are acceptable, several other states have followed suit by permitting this style of defeasance transaction.

Most aspects of the defeasance process are governed by the provisions in the original loan documents and the legal guidelines that support the REMIC structure. The ability of the borrower to designate the successor borrower and the type of securities permitted are outlined in the loan documents and negotiated at the loan’s origination. Regardless of whether the loan documents specifically reference a new note defeasance, loan servicers generally are willing to accommodate a request to structure a defeasance transaction in this manner in order to help the borrower reduce the mortgage recording tax.

For example, the mortgage recording tax rate in New York City is 2.8 percent of the loan principal amount. A state recording tax also is levied on new debt; the rate of this state tax depends on the county, and ranges from 0.75 percent to 1.3 percent. Considering only the city tax for a New York City property, a borrower who refinances a $30 million loan with $40 million in debt would have to pay $1,120,000 in taxes ($40 million x 2.8 percent). In a new note defeasance, $840,000 in mortgage recording taxes are saved by structuring the transaction to cover only the $10 million gap and paying $280,000 ($10 million x 2.8 percent) in taxes.   

Also in a new note defeasance, the original borrower assigns the existing loan to the refinancing lender in lieu of satisfying the mortgage, thus maintaining the mortgage recording tax already paid on the existing debt. Instead, the borrower only is subject to a recording tax on the amount by which the new loan exceeds the original principal balance of the existing loan. Any release of the old mortgage is eliminated.   

Steps in the Process

To begin the process, the original borrower executes a defeasance note in the amount of the original note’s current outstanding balance with terms identical to the original note in favor of the new lender. To secure the defeasance note, the borrower executes a pledge agreement pledging the defeasance collateral to the new lender.  

At closing, the trust assigns the original note and mortgage to the new lender, and in exchange, the new lender transfers the defeasance note and the pledged defeasance collateral to the trust. The trust now has a lien on the defeasance collateral and the new lender a lien on the asset.  

The original borrower then assigns the defeasance note and the pledge agreement to the successor borrower who then assumes the obligations of the defeasance note.
After the defeasance closes, the trust holds the defeasance note secured by the defeasance collateral. The new lender holds the original note and the original mortgage. The borrower and new lender can now amend and modify the original note and mortgage to refinance without paying the recording tax, or can increase the loan amount by paying tax only on the amount by which the note is increased.

When deciding whether to move forward with a new note defeasance, it is important to consider whether the new debt amount is large enough, when compared to the percentage of mortgage recording tax, to warrant the additional legal fees that will be incurred by the servicer’s counsel and the new lender’s counsel. If the decision is made to move forward with a new note transaction, borrowers will want to bring both the new lender and the new lender’s counsel on board early in the process as they are a party to the defeasance documents.

A standard defeasance can be a daunting endeavor, and a new note defeasance can seem like an endless stream of paperwork. However, the savings a borrower could potentially realize make the extra effort worth the time and energy.






Step 1: Borrower executes a pledge agreement for defeasance collateral to new lender.

Step 2: Trust assigns original mortgage to new lender in exchange for the defeasance pledge agreement.

Step 3: Successor borrower assumes defeasance note obligations.

by Traci Jervis and Jen Kraft

Traci Jervis leads Chatham Financial’s western defeasance consulting services located in Denver. Contact her at (720) 221-3516 or tjervis@chathamfinancial.com.Jen Kraft manages client relationships for Chatham Financial, focusing on opportunity funds. Contact her at (484) 731-0015 or jkraft@chathamfinancial.com.Why Defease Now?Defeasance language appeared in fixed-rate loan documents as early as 1995, but up until 1999, no one had tackled the onerous process. From 1999 through 2002, only a handful of defeasance transactions had taken place. Slowly but surely, attorneys, accountants, custodians, consultants, and a wide range of other third parties began to unravel the complicated process and became much more comfortable with defeasance as a whole. A committee designated by the Commercial Mortgage Securities Association developed a standard set of core defeasance documents and the attorneys working with servicers became more familiar with the defeasance requirements. These steps were driven by the need to defease due to commercial property’s skyrocketing values. Declining capitalization rates and climbing property values provided the impetus for more transactions in association with both property sales and refinances. In addition, the rise of the commercial mortgage-backed securities industry was making credit readily available for most borrowers. It was not uncommon for borrowers to refinance or sell their properties for twice the original purchase price that they had paid only a few years prior, thus allowing borrowers to take advantage of this tremendous equity build-up.Fast forward to 2009: Credit is much more difficult to acquire, property values have declined, and CMBS issuance has virtually dried up. Defeasance transactions have dropped off significantly. In fact, the total balance defeased in 2008 decreased by more than 75 percent from 2007’s activity, according to Realpoint. However, some borrowers still are executing defeasance transactions to secure new financing in today’s market. With the tightening of the credit markets, many borrowers are facing maturing debt in the next one to three years, along with the uncertainty of finding and securing available funds to pay off or refinance their loans. While the cost to complete defeasance transactions may be expensive in the current Treasury rate environment, it is worth the price to many borrowers to avoid defaulting on their loans. By going through defeasance transactions, borrowers are able to get out from under their existing loans to take advantage of available financing now, instead of taking a chance that there will be funds available down the road. Many borrowers have begun looking for replacement debt much earlier than they have in the past, and given today’s uncertainty in all markets, those that find debt that is available now may not wish to wait until their current loan can be paid off at par. In the current market the cost of defeasance may be worth the certainty. Defeasance Who’s Who       Involved parties    Role       Original borrower    Wishes to be released from loan obligations       Original borrower’s counsel    Reviews core defeasance documents on borrower’s behalf       Servicer    Responsible for paying the bondholders and administering the trust that holds the pool of loans; authorizes the defeasance transaction       Servicer’s counsel    Represents the servicer; drafts core defeasance documents       Successor borrower    Assumes the future financial obligations of the loan; generally formed by a third party       Successor borrower’s counsel    Represents successor borrower; ensures entity is set up correctly and is in compliance with rating agency and servicer requirements       Certifying accountant    Certifies the sufficiency of the defeasance portfolio        Securities intermediary (custodian)    Holds the defeasance collateral in a segregated account and ensures debt service requirements are met each month        Rating agencies    Rate and monitor the REMIC trust; review defeasance transaction to ensure transaction is executed according to loan document requirements        Title company/escrow agent    Responsible for releasing all wire payments and recording the new mortgage and release documents        Defeasance consultant    Coordinates the entire process, structures the defeasance portfolio and arranges its purchase, and often forms the successor borrower      

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