In light of the recent "return" of some CMBS (Commercial Mortgage-Backed Securities) loan originators to the capital markets, and the outstanding volume of pre-2008 CMBS loans, now is an ideal time for a brief overview of CMBS defeasance. Defeasance and loan prepayment yield a similar result for the borrower – release of the deed of trust – but they provide a much different result for the lender – satisfaction of the promissory note when the loan is prepaid, versus assumption and continuation of the note when the loan is defeased. Note: This article applies to performing loans, and is not intended to address defaulted loans.
Prepayment. Many traditional commercial mortgage lenders require payment of a premium as a condition to prepayment of the loan. This premium compensates the lender for any loss resulting from having to reinvest its funds in a new investment with a lower return. Premium formulas are often based on the yield of a U.S. Treasury security with the same maturity date as the promissory note. When the loan is prepaid, the note is cancelled and the lender releases its deed of trust.
Defeasance. Unlike traditional mortgage lenders, CMBS "lenders" – holders of bonds secured by a bundle of commercial mortgage loans – are averse to prepayment; they want to receive their scheduled monthly payments through the original maturity date. To provide this payment stream, the loans require defeasance as a condition to release of the deed of trust. With defeasance, the borrower purchases a portfolio of government securities (usually U.S. Treasuries) that are pledged as collateral for the loan in place of the real property. A new entity assumes the borrower's obligations under the note, and the lender releases the borrower going forward and releases the borrower's real property. The note remains in place, secured by the government securities. As each loan payment comes due, the proceeds of some of the securities are applied to make the payment.
Defeasance Issues. While defeasance and prepayment have the same ultimate result for the borrower – release of the deed of trust – there are more hurdles and costs associated with defeasance. First, there will be a mandatory lockout period for defeasance. Traditional lenders may restrict prepayment for an initial period, but that period is negotiable; CMBS loans, on the other hand, are subject to a non-negotiable defeasance lockout period (required by tax regulations) that usually ends upon the earlier of two years after loan securitization or four years after the loan closing. Second, while the acquisition price for the securities portfolio may be comparable to a typical prepayment premium, defeasance ends up costing more than prepayment because of the many other expenses (including fees for defeasance consultants, loan servicer, lender’s account custodian, and attorneys for the lender, the successor entity and the borrower). Defeasance expenses can approach six figures, while in a prepayment the borrower often pays only nominal lender fees for the payoff and release. Finally, not only is defeasance more costly than prepayment, it will also require more of the borrower's time and patience. Defeasance is a complicated process, requiring creation of a securities portfolio, confirmation that the portfolio will satisfy amounts due under the note, assumption of the loan and assignment of the securities to a successor entity, pledge and delivery of the securities, and negotiation of transaction documents. Most borrowers hire a defeasance consultant to coordinate the transaction.
Negotiation of Prepayment Rights. Many borrowers believe CMBS loans can never be prepaid and must always be defeased. The reality is that prepayment can be negotiated at the time the CMBS loan is originally made, but the borrower can expect to pay for this flexibility in the form of a higher interest rate on the loan. Considering the added steps and expenses associated with defeasance, there are certainly situations that may warrant paying the higher rate.
Otten Johnson's attorneys have substantial experience counseling clients with their real estate matters. For more information on this Client Alert please contact any of the attorneys in the Real Estate practice group (for a listing, click here).