Understanding Loan Defeasance in Commercial Real Estate
If you’re a commercial real estate investor, chances are you’ve come across the term “defeasance” in loan agreements or discussions about refinancing or selling a property. But what does it mean, and why is it important? This blog breaks down the defeasance process, explains its benefits and answers some common questions.
Defeasance Definition
To define defeasance, think of it as a financial tool that helps borrowers work around restrictions on early loan repayment. Most CMBS and Freddie Mac fixed rate loans include a prepayment restriction clause, which prevents borrowers from paying off their loan ahead of schedule. This protects the lender’s expected interest income and ensures they receive a predictable stream of payments.
Defeasance provides a workaround by replacing the original property collateral with a portfolio of secure assets, such as U.S. Treasury bonds or Agency bonds, that generate enough cash flow to cover the remaining loan payments to the loan maturity date. This way, the lender receives their agreed-upon payments, and the borrower is free to sell or refinance the property.
In short, defeasance is not a payoff. It is a substitution of collateral and an assumption by a successor borrowing entity. In this process, the property is released from the lien and the borrower is released from the loan obligations going forward.
How the Defeasance Process Works
Defeasance may sound complicated, but it follows a structured process designed to protect both the borrower and the lender. Here’s a step-by-step breakdown of loan defeasance in commercial real estate:
- Review the Loan Agreement
Start by reviewing your loan documents to ensure defeasance is allowed, as not every loan will permit defeasance. The prepayment restriction clause will typically lay out the specific requirements for how to proceed.
- Line Up the Transaction
Whether you’re planning to sell the property or refinance the loan, you’ll need everything ready before initiating defeasance. For a sale, this means having a buyer and purchase agreement in place. For refinancing, ensure your new loan is approved.
- Build Your Team
A successful defeasance requires collaboration with experts. This includes defeasance consultants who calculate costs, manage the logistics, and ensure the process adheres to your lender’s rules in addition to attorneys, financial advisors and other professionals.
- Lender Notification and Deposit
Typically, a servicer is assigned as the lender for securitized loans where defeasance is required. The loan agreement often requires a 30-day notice be provided to the servicer, and the servicer will also require a deposit. Depending on the servicer, the deposit amount can range from $25,000 to $50,000.
- Defeasance Legal Checklist
Upon receipt of the notice and deposit, the servicer will assign counsel. Their counsel will circulate a legal checklist of items that need to be completed prior to closing. In addition, the servicer’s counsel will draft a set of transaction documents that need to be signed by the borrower and the various parties to the transaction.
- Purchase Replacement Collateral
At the closing table, funds from your sale or refinance are used to purchase government or Agency bonds that are structured to generate cash flow that matches your remaining loan payments. These bonds are placed into an account where they are held for the remaining term of the loan.
- Release the Property
Once the bond portfolio is in place and paid for, the lender releases the property as collateral. The bank holding the bonds now has the responsibility of wiring the ongoing loan payments to the servicer each month.
- Transaction Finalization
With the property released, the sale or refinance can be completed. Proceeds from the transaction – after covering the cost of buying bonds, defeasance fees and other expenses – go to you.
It’s important to note that the sale or refinance and the defeasance are carefully coordinated to happen simultaneously, minimizing risk for all parties involved.
Why Investors Use Defeasance
Defeasance may sound like an extra step, but if your loan allows it, the process can offer some key advantages for commercial real estate investors. Here’s how loan defeasance can work in your favor.
- Unlock Flexibility
Loans with a prepayment restriction clause can limit your ability to sell or refinance a property early. Defeasance lets you bypass these restrictions, giving you the flexibility to act when market conditions are favorable or new opportunities arise.
- Capitalize on Property Appreciation
If your property has increased in value, defeasance enables you to sell it for a profit or refinance it to pull out equity. This can be a strategic move to grow your real estate portfolio or reinvest in higher-yield opportunities.
- Avoid the 1% Yield Maintenance Premium
Most loans with yield maintenance payoff requirements have a minimum 1% prepayment premium. With defeasance, there is no minimum premium. In today’s interest rate environment, some loans will have a defeasance cost close to $0 or even costs that are less than the current principal balance of the loan.
Key Considerations
While defeasance offers flexibility and financial benefits, it’s not without costs. The price of the bonds, legal fees and consultant expenses can add up, so it’s essential to weigh these costs against the potential gains of selling or refinancing your property.
Additionally, the process requires careful coordination with help from professionals who specialize in loan defeasance. With the right planning and support, defeasance can be a powerful tool for commercial real estate investors.
Final Thoughts
Defeasance can seem complex at first glance, but understanding its mechanics and benefits helps commercial real estate investors make well-informed decisions. By offering a solution to the limitations imposed by a prepayment restriction clause, this process unlocks flexibility and enables you to take advantage of opportunities in the market. Whether you’re looking to cash in on property appreciation or secure better loan terms, defeasance can be the key to achieving your financial goals.