The coronavirus-induced downturn has caused turbulence through all commercial real estate sectors, but these conditions also have opened opportunities for property owners. Low interest rates make this a good time to refinance a commercial mortgage. One way to accomplish this is via defeasance.
Defeasance can be used to obtain the property title to facilitate a sale or refinance at a lower rate. Borrowers are often fearful of defeasance, however, given its complexity and the higher upfront costs when interest rates are low. Due to today’s historically low interest rates, defeasance is expensive yet entirely worthwhile over the long term. Although the costs can range from tens of thousands to tens of millions of dollars, many borrowers can save more money via an interest rate reduction.
Defeasance presents property owners with the rare opportunity of trimming 200 to 300 basis points from their rate and moving into the 2% to 4% range. It also protects the borrower from likely interest rate increases over the next few years. By defeasing and securing a loan with a lower interest rate, the short-term cost of defeasance hedges against long-term interest rate risk.
Defeasance explained
Defeasance is the prepayment process required to pay off loans in commercial mortgage-backed securities (CMBS). Once a loan is defeased, a securities portfolio replaces the borrower’s payment stream and makes the remaining mortgage payments, allowing the borrower to either refinance or sell the property free and clear.
In today’s low-rate environment, defeasance is more expensive than when interest rates are high as the defeasance costs are tied directly to the price of U.S. Treasurys. Bond prices increase when interest rates fall, so the government Treasurys purchased for a defeasance portfolio are more expensive now. In a low-rate environment, defeasance is used to refinance, as the borrower can capture long-term savings via a lower interest rate. By contrast, when interest rates are high, the defeasance costs are lower, but the benefits of a refinance are much smaller.
With today’s low rates, many borrowers are scared off by the high upfront cost of defeasance, but this is a short-sighted view. Take, for example, a borrower with a 10-year, interest-only commercial mortgage with an original balance of $10 million and a 4% interest rate maturing in late 2023. The borrower is considering whether to defease the loan and refinance into a new 10-year loan at 3%, or to wait for the existing loan to mature and risk replacing the 4% loan with one priced at 5% or higher.
In this scenario, at today’s rates, the upfront defeasance cost and the interest payments on the new 10-year, 3% loan would be about $4.24 million. By contrast, if the borrower waits for the original loan to mature and obtains a new loan at 5% in 2023, the total cost would be $4.77 million. In this example, defeasance results in a net savings of about $525,000 over the loan term. There is risk, however: Any defeasance savings will depend on interest rates rising between today and loan maturity. In the above example, as long as interest rates in 2023 are above 4.27%, the defeasance will be profitable.
Many borrowers view defeasance as a Treasury-rate game, believing that they should delay their defeasance as long as possible to lower their costs. This strategy, however, most often only has a minimal impact on costs. Should the borrower on the loan in the above example choose to delay their defeasance until Treasury rates have risen by 10 basis points, their defeasance savings will be only about $32,000. Although these savings are certainly helpful, they pale in comparison to the potentially hundreds of thousands of dollars in increased interest costs that a borrower will incur by delaying their refinance.
Borrowers typically defease with one to four years left on the loan term. A defeasance company can usually pinpoint the time when savings are optimal.
Advising clients
For commercial mortgage brokers, it is a good idea to understand the basics of defeasance. Clients may call upon you to advise them and clear up common misconceptions.
Typically, a CMBS loan requiring defeasance is tied to larger and more valuable properties, but the size of a CMBS loan can vary between less than $1 million to well over $100 million, with an average loan size of roughly $15 million, according to Moody’s Investors Service. In 2018, defeasance activity for conduit and agency CMBS loans totaled nearly $18 billion, and there was another $4.1 billion defeased from 10 large loans and single assets, Moody’s reported. Multifamily properties were the most commonly defeased asset type from 2016 through 2018, followed by the retail and office sectors, Moody’s reported.
CMBS loans typically require the borrower to defease in conjunction with any refinancing or sale. Another major factor in determining the cost is the time remaining on the loan. Borrowers typically defease with one to four years left on the loan term but it depends on how much equity they have in the property. A defeasance company can usually pinpoint the time when savings are optimal.
Defeasance can take as little as two days but is generally a two- to four-week process. To avoid additional fees, borrowers must typically submit defeasance deposits 30 days in advance of closing, depending on the loan documents and loan servicer. The most important parties involved in a defeasance include the servicer, servicer’s counsel, defeasance consultant, accountant, custodian and, of course, the borrower and borrower’s counsel. The commercial mortgage broker is usually on the sidelines but is an interested party in the refinance that follows.
When a defeasance is handled properly, all of the essential parties are kept informed, including the mortgage broker and lender involved in the refinance. The lawyers work together to complete the legal documentation while the defeasance consultant takes care of the accounting, securities structuring, cost mitigations and keeping everything on track. This includes working with a Wall Street broker-dealer to create the securities portfolio.
It’s well worth a mortgage broker’s time to develop a relationship with an experienced defeasance company. In the coming year, more commercial mortgage refinances will likely involve a defeasance component. Defeasance is a small part of your client’s refinance and a good defeasance consultant will ensure that you will not have to worry about that side of the transaction. ●
