Careful analysis helps borrowers determine if defeasance is the right choice.
When defeasance became standard call protection for average commercial mortgage-backed securities loans in 1998, the timing could not have been worse for borrowers. Yields on government securities declined steadily in 2001 and 2002 making defeasance increasingly more expensive as many loans were emerging from the two-year lock-out period. This left many borrowers with a negative impression of loan defeasance.
But despite high defeasance premiums of 20 percent to 30 percent, a few borrowers have forged ahead after realizing that the same factors that make defeasance expensive also reduce a borrower's cost of funds and increase the proceeds on the next loan. Thorough analysis and due diligence often give a more complete picture of defeasance's true effect on a loan.
A Short History
In 1994, the concept of defeasance was borrowed from the bond market and adapted to the CMBS market. Simply put, defeasance is a substitution of collateral. A borrower uses proceeds from a refinance or sale to purchase a portfolio of U.S. government securities that is sufficient to make all of the remaining debt service payments under a note as they are due. The borrower pledges the securities to the lender, the lender releases the real estate from the lien of the mortgage, and the note actually remains in place.
Prior to adapting defeasance, yield maintenance provisions were the preferred form of call protection in CMBS loans. Both have the same theoretical underpinnings in that both replicate debt service payments using government securities. The difference is that in a defeasance, the securities portfolio actually is purchased and pledged to the lender, which makes debt service payments relatively certain, and in turn makes the CMBS more stable and reliable.
Investors were willing to pay more for the stability defeasance offered, and loan originators liked the increased profitability it brought to their securitization programs. By 1998, defeasance had replaced yield maintenance as the industry's standard call protection.
While lenders and investors preferred defeasance, it was not until 2001 and 2002 that average-size loans began to be defeased in significant numbers. But government securities yields were falling, and when borrowers saw that the securities cost was 20 percent to 30 percent more than the outstanding balance on their loan, many blamed it on defeasance. In fact, yield maintenance formulas are based upon prevailing rates on government securities, and yield maintenance penalties would have been just as high.
Borrowers who defeased loans in the last four years kept in check their visceral reaction to defeasance premiums and analyzed its effects on the underlying commercial real estate transaction.
For example, assume that a borrower owns a multifamily property with an existing first mortgage of $15,000,000 originated on Feb. 1, 2000, at an 8.25 percent interest rate. The property loan has a remaining term of five years and the current outstanding principal balance is $14,405,000.
The property currently has net cash flow available for debt service of $1,900,000, and the borrower can refinance now with a new 10-year loan and maximum loan proceeds of $23,034,000 at 5.58 percent. During the 10-year term of the new loan, the borrower will pay $12,081,000 in interest. In addition, the defeasance premium is estimated to be $3,280,000, so it costs the commercial real estate borrower approximately $15,361,000 over the 10-year term of the loan to refinance at this time.
The size of the defeasance premium suggests that it does not make economic sense to refinance now, but a borrower should look to the five-year forward 10-year Treasury rate and add 150 basis points to estimate the interest rate on a multifamily loan obtained in 2010. Projected proceeds in February 2010 would be approximately $21,304,000, resulting in an interest expense of $12,486,000 over the same 10-year period — the last five years of the existing loan and the first five years of the loan obtained at maturity.
In addition to interest costs, the borrower should figure opportunity costs of $5,349,000 that could have been reinvested from Feb. 1, 2005, until Feb. 1, 2010. This includes the equity obtained by refinancing now, which is new loan proceeds of $23,034,000, minus the $14,405,000 current outstanding balance and the $3,280,000 defeasance premium. At a rate of 10 percent per year over five years, that equals $2,727,000 in lost returns. Factor in the reduction in loan proceeds of $1,730,000 from waiting to refinance until the loan matures when interest rates are higher and the cost of waiting to refinance is an estimated $16,943,000.
In other words, based upon current economic indicators, with a 10-year horizon, it actually might cost the borrower $1,582,000 less to refinance now and pay the defeasance premium. If the five-year forward 10-year Treasury rate was closer to 6.2 percent as it has been in the last six months, the same analysis would show that refinancing now and paying the defeasance premium saves approximately $3,500,000 over waiting to refinance at the maturity date.
While there are other factors to consider, if a borrower can eliminate the emotional reaction to a high defeasance premium and analyze the whole transaction, the results may be surprising. Completing due diligence and having an idea of how long a property will be held allows borrowers to make informed business decisions without being intimidated by a high defeasance premium.