October 14, 2007 Stephen Aron Benson Real Estate Law

What is a defeasance transaction, and why are we hearing so much about it lately?

The concept of “defeasance” originated in the municipal bond market. In the 1990’s, the concept was adapted to the commercial real estate market in response to the increasing securitization of fixed-rate loans. To make these securitizations more attractive to investors, true prepayment of loans was restricted, enabling predictable cash flows. Loan documents first included defeasance provisions in about 1998 to create an avenue for borrowers to exit a securitized loan for a sale or refinance.

Defeasance is a substitution of collateral. The borrower uses proceeds from a refinance or sale to purchase a portfolio of securities that is sufficient to make the remaining debt service payments required by the loan. The securities are pledged to the lender who releases the real estate from the lien of the mortgage. The loan, however, is not paid off. The note remains outstanding, but is assigned by the borrower to a successor borrower, who makes the ongoing debt payments (cash flow comes from the securities).

The process typically involves a loan servicer, attorneys, an accountant (who determines what the “basket” of securities will be composed of), rating agencies, a securities intermediary, a title/escrow company, the refinance lender or the buyer’s lender, and usually, a defeasance consultant. A defeasance generally takes about thirty days to complete; coordinating all the parties and documents is the defeasance consultant’s job.

For borrowers with loans securitized in the commercial mortgage-backed securities (CMBS) market–many of which prohibit mezzanine financing and true prepayment–defeasance can be the only mechanism borrowers can use for extracting equity. The ability to extract equity due to increased property values may outweigh the costs incurred from defeasing the loan. For example, consider a multi-family property, which was purchased using a CMBS loan and was worth $20M (let’s assume that the loan was 75% or $15M). Now, 5 years later, the property, in a market like Arizona, may be worth $30M. While a purchaser may buy the property subject to the existing loan (if the original loan documents allow it), the new buyer may be unhappy with a loan with only 50% leverage. If the loan prevents subordinate or mezzanine financing and prohibits true repayment, then defeasance–allowing the new buyer to obtain a loan with better leverage–can be an attractive solution. The owner/seller has to weigh the costs of defeasance against the desire to extract equity from the property.

The cost associated with the defeasance is made up of two components: the securities cost and the transaction fees. The cost to purchase the securities is a function of the spread between the interest rate on the loan to be defeased and the yield on the securities portfolio on the date the securities are purchased. The actual cost of the securities is not determined until they are purchased at closing. Transaction costs include the fees of the various parties involved in the defeasance transaction.