As the real estate market has improved in many parts of the United States, and interest rates are poised to climb in the near future, many property owners are considering pursuing defeasance to exit their loans. Many, however, don’t really understand what’s involved.
Defeasance lets a borrower substitute collateral for the real property that had been securing a fixed-rate loan. A successor borrower takes over the loan, and future payments to the lender come from cash flow generated by the substitute collateral.
Defeasance allows you to exit a loan without incurring a prepayment penalty. It frees you to refinance or sell the property free and clear. The original lender gets the benefit of receiving the same cash flows from a less risky piece of collateral and without having to find new borrowers to replace the prepaid capital. If the lender issues mortgage-backed securities, defeasance boosts the value of the securities by improving the likelihood that investors will receive all of their principal and interest payments.
While defeasance doesn’t come with a formal penalty, expect to pay a quasi-penalty in the form of fees for your attorney, the lender’s attorney, an accountant, a securities intermediary, the successor borrower and its attorney, and a defeasance consultant.
Defeasance can pay off for borrowers if interest rates increase to a rate higher than that of the original loan. When rates climb, Treasury bonds and other fixed-income investments lose value and drop in price. Thus, you can purchase the necessary bonds for less than the amount required to prepay your loan, leaving you with extra cash. However, if the interest rate on the loan is higher than the portfolio’s Treasury rate, the cost of the portfolio to cover the outstanding loan balance will exceed that balance.
When interest rates are on the decline, and borrowers can lock in low-rate loans through refinancing, defeasance has an obvious appeal. But it can also be a wise strategy in a higher interest rate environment if you have sufficient equity in your property to cover the cost of the portfolio and the extra cost is still less than a prepayment penalty.
The availability of defeasance depends on whether the loan documents allow it. (For example, a loan may include a two- to three-year lockout period during which defeasance is blocked.) When entering loans, negotiate for the right to purchase the portfolio and include governmental agency securities, which often pay a higher yield than Treasury securities and, therefore, reduce your costs.