CAPITAL MARKETS: DEFEASANCE

APARTMENT FINANCE TODAY • MAY 2008

Credit Crunch Cuts Defeasance Activity

While apartment owners are the most likely to defease, falling values and declining liquidity make it a less attractive option.

By Brad Berton

When HVM Management Co. looked to sell a portfolio of seven communities in the Carolinas late last year, principal Hal McCoy realized most buyers would likely want to replace the lowleverage conduit loans on five of the properties, in order to minimize their equity contribution.

So given that the seven-year mortgages weren’t scheduled to mature for four more years, the Greensboro, N.C.- based entrepreneur also realized he’d need to defease the loans in order to close the sale.

Indeed, when McCoy and company cut an $81.5 million deal with Berkshire Property Advisors, the buyer opted for far higher leverage by bringing in fresh financing from Freddie Mac. As it turned out, the relatively modest “premium” McCoy paid in defeasing nearly $22 million in mortgage debt made for a successful sale.

While defeasance activity has fallen fast since the credit crunch brought turmoil to the conduit lending arena, McCoy’s deal illustrates that the complicated option can still be attractive under certain circumstances.

With Freddie Mac and Fannie Mae lending while conduits are on the sidelines, many apartment buyers are still able to make aggressive bids by financing acquisitions at attractive leverage levels and interest rates. McCoy’s impression is that Freddie helped Berkshire leverage the entire sale at about a 70 percent loan-to-value (LTV), compared to well below 40 percent for the defeased loans.

And although HVM had to buy enough government-backed securities to cover the remaining four years of debt-service obligations, the company’s loan documents allowed it to use Fannie and Freddie bonds as the replacement collateral (it helped that the coupon rate on the loans being defeased was just 4.48 percent). With the Fannie and Freddie bonds yielding higher rates than Treasury issues, the difference between the principal balance and the cost of the replacement collateral came to a modest $900,000.

Adding various other fees (see sidebar at end of this article) necessitated by the defeasance arranged through niche pioneer Commercial Defeasance, LLC, McCoy’s total cost was a bit more than $1 million— well worth it given the portfolio price.

Defeasance transactions had kept experts at Commercial Defeasance and other specialty consultants pretty swamped through mid-2007. A potent combination of rising property values and cheap and plentiful conduit debt pushed activity upward for several years running.

But volume has cratered with conduit lending activity, as values are more likely to be falling than rising, interest rate spreads have widened substantially, and LTV ratios determining total loan proceeds have become more conservative. Still, defeasance professionals cited several circumstances under which apartment owners might find defeasance an attractive option.

Concern that financing might become even more expensive, and lenders more conservative, has prompted some borrowers to defease lowleverage loans and get the best new deal they can today while also tapping built-up equity, said Buddy Cramer, founder of specialty consultant DefeaseIt in Dallas.

A typical situation is a borrower that’s been paying off a 10-year conduit loan for eight or nine years and prefers to lock in refi rates and terms sooner rather than later. “They fear the money won’t be there or will be even more expensive” when the loan opens for penalty-free pay-off, Cramer said.

Some borrowers anticipating a higher capital gains tax hike ahead have even opted for defeasance in order to sell a property and pay the prevailing 15 percent rate, said associate Stephen Liadis at defeasance consultant Waterstone Capital Advisors in Charlotte, N.C. “That’s the big wildcard” potentially affecting defeasance activity volume, said Liadis, referring to expectations that a Democratic president would look more kindly than a Republican on an increase in the capital gains tax rate.

The availability of new loan proceeds is what drove the defeasance boom, and the current absence of liquidity has cut transaction volume dramatically, Liadis and others said.

With Wall Street capital flowing feverishly through the first half of the year, a record $31.1 billion of securitized mortgages was defeased in 2007, according to an analysis by Credit Suisse. But by December, volume had already fallen below $1 billion—compared to an average of about $2.5 billion a month over the previous 12 months.

Transaction volume among leading defeasance consultants is probably down 70 percent or more, Liadis said. “Our marketing program used to be sitting in our offices waiting for the phone to ring,” he recalled, adding that Waterstone’s volume has fallen from 30 to 40 transactions monthly to just a handful.

Borrowers who would likely look to defease in order to sell or refinance on attractive terms in a more liquid environment are pretty much “caught in an artificial bind” today, said Stephen A. Edwards, a partner in Atlanta law firm Kilpatrick Stockton, LLP.

In other words, would-be buyers aren’t able to secure financing packages allowing for a purchase price that would justify the cost of defeasance. Nor do owners—even those with substantial built-up equity—see refinancing rates and terms being attractive enough to persuade them to pull the defeasance trigger today, Edwards said.

As Federal Reserve policymakers move aggressively to reduce short-term interest rates, the higher cost of replacement- collateral securities also makes defeasance a more costly proposition today than just a year ago, Edwards said. As falling yields push up the prices of short-term Treasury bonds, it costs borrowers more and more to purchase the amount of replacement securities required to meet the remaining debtservice obligations.

In normal environments, the cost of the new debt an owner or buyer would tap for a refinance or sale tends to move up or down with Treasury yields, Edwards said. In today’s marketplace, however, commercial mortgage rates have generally been rising with the widened spreads, even as Treasury yields have tended to fall with each Fed rate cut.

“You could say we’ve got something of a perfect storm of negative arbitrage,” Edwards said, “and it’s putting a crimp on defeasance activity.”

The better news for the multifamily sector is that unlike their counterparts in other income-property categories, many borrowers have access to the generally more attractive rates and terms the Fannie and Freddie are quoting. Multifamily collateral accounts for about a third of all conduit loans being defeased.

Indeed, the apartment sector appears to be accounting for more defeasance transactions amid the slowdown than any other income-property category, DefeaseIt partner Joe Tillotson said.

Given the billions of dollars worth of conduit loans opening up for defeasance in coming years, Cramer and Tillotson say the market will revive. “It will come back as liquidity returns, but it looks like it’s going to take a while— probably into next year,” Cramer conceded.

Sidebar: Defeasance Fees

The defeasance option became popular in recent years as a practical means for retiring conduit mortgages not yet open for penalty-free pre-payment. Rather than having the original borrower continue making mortgage payments, a “successor” borrowing entity instead makes payments from interest earned through government-backed securities purchased as a replacement for the real estate originally pledged as collateral.

The securities’ interest payment schedules are timed to match debt-service obligations through the balance of the loan term. For example, a borrower that took out a $5 million 10-year loan (amortizing over 30 years) at a fixed 7 percent coupon rate nine years ago would have a current principal balance of about $4.45 million.

In late March, the replacement-collateral securities required to cover the $33,265 debt-service obligations through the remaining one-year balance of the loan term would likely cost $4.69 million, factoring to a so-called “defeasance premium” of about $246,450. Additional transaction costs would run roughly $53,500, including: the loan servicer’s processing and legal fees, the defeasance consultant’s fee, and custodian, successor-borrower, and accountant fees.