Defeasance Definition: How Defeasance Relates to CMBS Loans
Borrowers often consider conduit loans’ strict prepayment penalties to be one of their major downsides. Many CMBS loans must be prepaid in a process called defeasance, which involves a borrower purchasing alternative securities, often U.S. Treasury bonds, to replace the collateral and interest income that the lender will lose as a result of prepayment. Defeasance can be a complicated process, the details of which will typically be spelled out in a borrower’s loan agreement.
Defeasance Allows Borrowers to Prepay Conduit Loans
Borrowers often consider conduit loans’ strict prepayment penalties to be one of their major downsides. Many CMBS loans must be prepaid in a process called defeasance, which involves a borrower purchasing alternative securities, often U.S. Treasury bonds, to replace the collateral and interest income that the lender will lose as a result of prepayment. Defeasance can be a complicated process, the details of which will typically be spelled out in a borrower’s loan agreement.
How Defeasance Actually Works for CMBS Borrowers
In order to conduct defeasance properly, borrowers often need a team including one or more lawyers, accountants, and financial advisors in order to assist them through the process. In most cases, a borrower will want to work with an experienced broker-dealer who can tailor a group of securities that can generate sufficient cash flow to make all remaining payments on the loan through maturity. In addition, a securities intermediary will be needed, who can hold the bonds in a separate account (similar to escrow), in the borrower’s name, but for the lender’s benefit. The intermediary will actually make the monthly debt payments to the lender with the cash proceeds of the securities.
When Is Defeasance a Good Idea?
When determining whether to attempt defeasance, borrowers should look at the interest rates for the securities they will have to buy as replacement collateral. When interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance will exceed the loan’s remaining balance. However, if current interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance will actually be less than the remaining balance of the loan. In this situation, defeasance can actually save a borrower money, at least in theory. However, since borrowers will typically have to pay for the services of several consultants, such as broker-dealers, lawyers, and accountants, defeasance rarely saves borrowers money in practice. In fact, the services of these experts often ends up costing between 10% and 30% of the entire loan balance, which can make defeasance a somewhat expensive process.
Whether defeasance is a good idea also depends on the exact nature of the defeasance stipulations in the borrower’s loan agreement. While most CMBS lenders require borrowers to use U.S. Treasury bills to conduct defeasance, others may allow them to use agency bonds, such as Freddie Mac or Fannie Mae bonds, which are typically less expensive.
Instead of Defeasance, Borrowers May Want to Find a New Buyer to Assume Their Loan
Since defeasance can be so costly, many borrowers may find that it’s more efficient to simply find a buyer who can assume their loan. The vast majority of conduit loans are fully assumable with a small fee, so as long as the original borrower can find a new, qualified borrower for the loan, they can exit the property without conducting defeasance.
Related Questions
What is a defeasance clause in a CMBS loan?
A defeasance clause in a CMBS loan is a clause that allows a borrower to prepay a loan without penalty. This is done by replacing the loan with a portfolio of securities that generate sufficient cash flow to make all remaining payments on the loan through maturity. In order to conduct defeasance properly, borrowers often need a team including one or more lawyers, accountants, and financial advisors in order to assist them through the process. In most cases, a borrower will want to work with an experienced broker-dealer who can tailor a group of securities that can generate sufficient cash flow to make all remaining payments on the loan through maturity. In addition, a securities intermediary will be needed, who can hold the bonds in a separate account (similar to escrow), in the borrower’s name, but for the lender’s benefit. The intermediary will actually make the monthly debt payments to the lender with the cash proceeds of the securities.
How does defeasance work in a CMBS loan?
Defeasance allows borrowers to prepay conduit loans. In order to conduct defeasance properly, borrowers often need a team including one or more lawyers, accountants, and financial advisors in order to assist them through the process. In most cases, a borrower will want to work with an experienced broker-dealer who can tailor a group of securities that can generate sufficient cash flow to make all remaining payments on the loan through maturity. In addition, a securities intermediary will be needed, who can hold the bonds in a separate account (similar to escrow), in the borrower’s name, but for the lender’s benefit. The intermediary will actually make the monthly debt payments to the lender with the cash proceeds of the securities.
Defeasance can be a cost-effective way to prepay a loan depending on the market environment. When interest rates rise, treasury bonds typically lose value — which lowers their cost. This enables investors to purchase the required bonds for much less than what would be required to prepay the loan, which leads to substantial savings. Even when interest rates are falling, the cost to an investor may not be much worse than what they would be required to cover through yield maintenance.
What are the benefits of a defeasance clause in a CMBS loan?
The main benefit of a defeasance clause in a CMBS loan is that it allows borrowers to prepay the loan without incurring a prepayment penalty. This can be especially beneficial when interest rates are falling, as the cost of defeasance may not be much worse than what would be required to cover through yield maintenance. Additionally, if current interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance can actually be less than the remaining balance of the loan.
It is important to note that the exact nature of the defeasance stipulations in the borrower’s loan agreement will determine whether defeasance is a good idea. While most CMBS lenders require borrowers to use U.S. Treasury bills to conduct defeasance, others may allow them to use agency bonds, such as Freddie Mac or Fannie Mae bonds, which are typically less expensive.
Finally, it is important to consider the cost of the services of several consultants, such as broker-dealers, lawyers, and accountants, which can make defeasance a somewhat expensive process.
What are the risks associated with a defeasance clause in a CMBS loan?
The main risk associated with a defeasance clause in a CMBS loan is the cost. Defeasance can be a costly way to prepay a loan depending on the market environment. Additionally, defeasance is a complicated process, and the exact details of each defeasance transaction are typically detailed in the borrower’s loan agreement. This can lead to confusion and potential mistakes. Lastly, when interest rates rise, treasury bonds typically lose value, which can lead to higher costs for investors.
What are the costs associated with a defeasance clause in a CMBS loan?
The cost of defeasance can vary depending on the market environment and the exact nature of the defeasance stipulations in the borrower’s loan agreement. Generally, the services of experts such as broker-dealers, lawyers, and accountants can cost between 10% and 30% of the entire loan balance. Additionally, borrowers may need to purchase U.S. Treasury bills or agency bonds, such as Freddie Mac or Fannie Mae bonds, to conduct defeasance. The cost of these securities will depend on the current interest rates.
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