Understanding the ins and outs of defeasance

Prices for commercial real estate are trending up in many parts of the country, and interest rates may soon follow, although at a slower pace. In such an environment, some property owners are starting to think about exiting their loans early through defeasance. That’s a big decision, though, that requires a solid understanding of what’s involved.

In a nutshell

Defeasance allows you to avoid traditional prepayment loan penalties, such as those associated with yield maintenance, by substituting collateral. Typically, you’ll replace the real property that’s been securing the loan with a portfolio of U.S. Treasury securities, which have maturities that align with the debt service schedule. Generally, a special purpose entity — the successor borrower — assumes the borrower’s role and makes the remaining payments from the cash flow the securities generate.

Once the successor borrower is in place, you can refinance or sell the real property. The lender benefits from receiving the same payments from a more reliable piece of collateral. For lenders that issue mortgage-backed securities, defeasance also increases the value of the mortgage-backed securities by improving the odds that investors will receive all of their principal and interest payments.

Timing issues

Defeasance may be appealing in a low interest rate climate, because it lets borrowers lock in low-rate loans by refinancing. Any cost-benefit analysis should always include the income tax impact of the defeasance transaction. This can be significant and will depend on the structure (legal or in-substance), the economics (defeasance premium or discount), and whether it’s done in conjunction with a refinancing, a sale or a like-kind exchange of the property.

Defeasance is generally worth considering if:

  • You have enough equity in a property to cover the substitute collateral’s cost, and
  • The related fees (such as fees for attorneys, accountants, the successor borrower and a defeasance consultant) don’t exceed the applicable prepayment penalty you’d otherwise have to pay to exit.

Obviously, you’ll be better off if you can refinance before interest rates begin to climb, as they’re expected to do in the next few years.

Some borrowers forgo defeasance, opting to wait for a loan’s 30- to 180-day open prepayment window. But those who wait may find that interest rates have increased, driving up their borrowing costs.

For many borrowers, the optimal time to pursue defeasance is 12 to 18 months before loan maturity, which gives them time to monitor rates, capital market conditions and costs so they don’t end up with a higher interest rate. It’s important to choose securities that maximize cash flows and not just satisfy the payment requirements.

Negotiate upfront

Defeasance isn’t always practical based on existing loan documents. To give yourself more options, negotiate future loans to include defeasance-friendly provisions, such as the rights to select the successor borrower and choose non-Treasury securities for the substitute portfolio.