CAPITAL MARKETS: REFINANCING & DEFEASANCE

APARTMENT FINANCE TODAY • SEPTEMBER 2007

Defeasance Goes Discount

By Jerry Ascierto

Earlier this year, something unusual started happening to multifamily borrowers with defeasance options. They were able to earn a profit on defeasance transactions after rates rose enough to give them the option of paying less for the collateral securities than the amount owed on the loans.

“What’s happening is that borrowers are defeasing at a discount relative to what their outstanding principal balance is,” said John Hosmer, CEO of Charlotte, N.C.-based Commercial Defeasance, Inc.

Defeasance of a securitized commercial mortgage is a relatively young process, replacing yield maintenance as the prepayment option of choice in the late 1990s. Defeasance is a collateralsubstitution process, where the borrower replaces the lender’s security, usually a real property, with a governmentbacked security.

When interest rates fall, the cost of defeasance goes up since the securities used as collateral become more expensive, but borrowers are able to refinance at a better rate. In a high-interest rate environment, the reverse is true: Bonds are less expensive, but the refinancing rate is less beneficial. Borrowers seeking to defease in a high-interest rate environment often do so to free up the property for a sale.

Interest rates have been at historic lows ever since defeasance became prevalent, but many now expect rates to rise. “Defeasance is a fairly new phenomenon,” said Alan Hammer, a Roseland, N.J.-based partner in the Real Estate Practice Group of law firm WolfBlock, and a private investor involved in the ownership of more than 10,000 apartment units. “If rates do go up, you could defease a loan into a profit for yourself, which is something that pretty much nobody has seen before.”

To illustrate, let’s say a borrower has a $5 million outstanding principal balance on a loan with a 5.5 percent interest rate. If yields on U.S. Treasuries are at 4.5 percent, the borrower has to buy more Treasuries to match the 5.5 percent rate on the loan. But if interest rates rise to 6.5 percent, the borrower can buy fewer Treasuries to match that interest rate on the loan.

“So, you could actually put up $4.5 million worth of cash to buy the securities that will match your payments on your $5 million outstanding principal balance of the remaining term,” said Hosmer.

Commercial Defeasance has already done four such transactions this year, one of which, for a multifamily property in Texas, used securities from government-sponsored entities as collateral for a loan with a 4.29 percent interest rate.

A wave of discount defeasance transactions is just beginning to build. “There were a lot of loans originated in 2003 to 2005 that had low interest rates,” Hosmer said. “That’s going to make it more likely that at some point over their 10-year cycle that yield on Treasuries will be high enough that they could defease at a discount.”

Additionally, more small loans may defease as interest rates rise. Historically, defeasance works well on larger loans since there are fees inherent in every transaction that are the same whether you’re dealing with a $1 million or a $10 million loan.

Only 2.5 percent of all 2006 defeasance volume accounted for loans of less than $2 million, compared to 3.2 percent in 2005. In contrast, loans of more than $50 million made up 32 percent of all defeasance activity last year, up from 24 percent in 2005, according to Moody’s annual commercial mortgage- backed securities report, published in March.

In a rising interest rate environment, though, the advantages of defeasance may outweigh the fees for smallloan borrowers. Small-loan borrowers who a year ago were looking to refinance might have thought the cost of defeasance was prohibitive, said Traci Jervis, a Denver-based defeasance consultant with Chatham Financial.

“Now, they’ve paid down a year’s worth of principal and if Treasuries keep rising, then the cost of their defeasance is going to become significantly cheaper,” said Jervis.

Since standard conduit loan terms often steer control of the defeasance process to the lender, borrowers should be on the lookout for opportunities to wrest back that control. Provisions stipulating when, how, and what securities are purchased, and who purchases them, can help to give borrowers maximum control over the process down the road.

“The more control a borrower has over the defeasance process, the better off they’re going to be,” advised Traci Jervis, a Denver-based defeasance consultant with Chatham Financial.

The following are some examples of contractual language that borrowers may want to use when structuring a conduit loan, courtesy of Chatham Financial.

Avoiding long lockout periods: Real Estate Mortgage Investment Conduit (REMIC) regulations require that loans be prohibited from defeasance for two years, starting from the date of securitization. It’s important that borrowers limit the lockout period to only these two years to ensure flexibility. Sample borrowerfriendly language: “Borrower may cause the release of the Property the earlier of three years from the date of this note, or two years from the startup day of the REMIC trust.”

Providing a defeasance deposit instead of defeasance collateral: Borrowers would do best to purchase the securities used as collateral themselves, rather than cede that control to lenders. Many conduit loans require the borrower to supply cash that’s then used by the lender to purchase the securities. But that borrower then has no control over the selection of the servicer and would be responsible for any expense associated with the purchase. Sample language: “Borrower shall deliver to Lender the Defeasance Collateral.”

Choosing agency securities: Borrowers should demand the option to purchase the securities of government-sponsored enterprises like Fannie Mae and Freddie Mac, instead of accepting the standard loan language that strictly defines defeasance collateral as U.S. Treasury bonds. Because agency securities offer higher yields and come with a more reasonable price tag, this provision has the biggest impact on the cost of a defeasance transaction. Sample language: “Government Securities as defined in section 2(a)(16) of the Investment Company Act of 1940.”

Naming the “successor borrower”: The borrower should make sure that it has the right to name the successor borrower, which is the entity that buys the securities being used as collateral. Having that control ensures competitive pricing, as the borrower can direct its defeasance consultant to hold a competitive auction. Sample language: “Borrower shall establish or designate a successor entity, which shall be approved by the Rating Agencies.”