Defeasance
What is Defeasance?
The term defeasance is generally used to describe a stipulation in a finance contract that voids a bond or loan on a balance sheet in the event of the borrower setting aside cash (or bonds) whose value would be sufficient for servicing the debt. In this scenario, the borrower specifically sets aside an adequate amount of liquidity to pay off the bonds; this causes the outstanding debt and the cash balance to offset each other on a balance sheet – rendering both unnecessary to record.
Defeasance in action, is the replacement of the collateral of a loan with securities that will provide a lender an equivalent return. The favored and most common type of securities used are fixed-rate government bonds. In most cases, borrowers purchase U.S. Treasury bonds in order to conduct defeasance, though in some cases, other types of government-backed securities are accepted. What truly matters, is that the total value of the bonds is able to provide to the lender, at the very least, the same amount of income as did the loan itself. This is done so that the lender does not experience any loss of income as a result of the borrower prepaying their loan, and thus negating the receival of interest. Prepayment on a multifamily loan is a common occurrence for borrowers who want to sell the property before the term of the loan is up.
Just like a new multifamily or commercial real estate investor would generally rather work with a broker than deal directly with lenders themselves, defeasance generally requires the aid of expert consultants if it is to be executed properly. The concept may sound simple enough, but overall, defeasance can be a somewhat complicated ordeal for the parties involved to work through. Such intricacies include purchasing the exact amount of bonds (equal in value to the loan balance), securing them in the proper way, and recording and filing property for tax purposes. Additionally, there is typically a fair amount of negotiation and communication with the lender that is required throughout the entire process.
The Defeasance Clause
As part of a commercial mortgage transaction, a defeasance clause grants the borrower the right to secure the title (or deed) for the collateral property once the debt is paid in full. Until that time when the note has been satisfied (paid in full), the financial entity backing the loan retains all rights to the title, maintaining it as collateral towards the associated debt obligation.
Defeasance and Prepayment Penalties
Defeasance in apartment finance accounts for contractual provisions which nullify the contractual agreement in which it is contained. The provisions are usually intricately worked out and set between the two parties, with the lion’s share of requirements levied on the buyer, who must meet specific criteria before the seller is willing to release their interest in a property. Defeasance allows the borrower to essentially set enough funds to cover his or her debt obligations regarding the transaction aside, effectively eliminating the debt obligation altogether without incurring the common burden of prepayment penalties.
In multifamily and commercial finance, prepayment penalties exist as a variety of ways that a borrower can potentially reimburse their lender for pre-paying their loan balance. The most common prepayment penalties include yield maintenance, step-downs, and soft-step downs. Defeasance, however, is yet another common type of prepayment penalty, and is often a readily available option, particularly in the case of CMBS loans and for certain Fannie Mae and Freddie Mac apartment loans.
When is Defeasance a Good Idea?
Whether or not defeasance is a worthwhile pursuit for a commercial or multifamily real estate borrower depends on a variety of variables such as current interest rates and other factors. If market interest rates were to increase in value above the given rate of the mortgage, then a borrower may actually profit from defeasance. The exact terms allowed within the defeasance agreement by a lender also have a huge impact on whether defeasance is a smart choice for a borrower. Sometimes even the type of bonds purchased are a huge factor, as the borrower, if allowed in the agreement, may find the usage of Fannie Mae®, Freddie Mac®, or Ginnie Mae® bonds to be significantly less expensive than the preferred U.S. Treasury Bonds.
Whether or not defeasance is best for any individual borrower depends on their individual situation; however, there is no argument denying the fact that defeasance is almost always a good scenario for lenders. Inherently, bonds present a much lower prepayment risk than commercial or multifamily mortgages. After all, there is a plethora of factors such as low occupancy rates, legal issues, fraud, and a wealth of other issues that could cause a borrower to default, while it would take a serious economic cataclysm for the U.S. Treasury, Fannie or Freddie to default on paying the yield on their bonds.
Deciding on Defeasance vs. Yield Maintenance
In some cases, particularly when it comes to CMBS loans, a borrower may have to make a choice between yield maintenance and defeasance as loan prepayment penalties. Choosing between the two options can be tricky, but paying attention to the exact terms of a lender’s defeasance agreement can help the choice become a bit easier to make. Defeasance is oftentimes considered more optimal when bond interest rates are compounded monthly and payments are calculated to the maturity date. More so when the overall yield maintenance is greater. However, yield maintenance can become a much more desirable option if bond interest rates are compounded annually and payments are calculated to the loan’s prepayment date (and when the overall yield maintenance prepayment penalty is smaller).
Explore Alternative Prepayment Penalty Options:
- Learn about Yield Maintenance
- Learn about Step-Down Prepayment Penalty
What is the process of defeasance in commercial real estate?
Defeasance is a common type of prepayment penalty for CMBS loans and even certain types of Fannie Mae and Freddie Mac multifamily financing. The defeasance process replaces the collateral of a loan with securities which provide the lender with an equivalent return. Usually, defeasance involves fixed-rate government bonds.
The process of defeasance is generally complex and requires a team of experienced accountants and legal experts to execute it successfully. The costs of defeasance are increased by the intensive capital investment into the replacement collateral - the bonds - used to offset the yields. Additionally, a certain amount of negotiation and communication with the lender will typically be required throughout the entire process.
For more information, please consult a defeasance consultant.
What are the benefits of defeasance for apartment loans?
Defeasance can be a great option for apartment loans, as it can provide a variety of benefits for both the borrower and the lender. For the lender, defeasance removes any risk of repayment and replaces it with returns guaranteed by U.S. Treasury bonds (or, in some cases, bonds issued by Fannie Mae, Freddie Mac, or Ginnie Mae).
From the borrower's perspective, there are also some advantages to defeasance, but they depend on the borrower's individual situation and wider economic conditions and trends. If interest rates are expected to rise, defeasance can be particularly advantageous for a note with a variable rate. By replacing the loan’s collateral with bonds, a borrower doesn’t need to be concerned with rising rates.
Defeasance can also have accounting benefits. By replacing the collateral with securities, the debt is effectively removed from a company’s balance sheet. This makes a commercial real estate investor’s books far less complex when it comes to logging debt service transactions.
Generally, a defeasance consultant will be able to give you a no-cost estimate to determine whether it's ideal for you or not.
What are the risks associated with defeasance in commercial real estate?
The main risks associated with defeasance in commercial real estate come down to cost. The process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully. As these aren’t single-day transactions — and can take months, depending on the situation — this time factor can make the process itself prohibitively expensive. Additionally, beyond the staff requirements, defeasance’s costs are also increased by the intensive capital investment into the replacement collateral — the bonds — used to offset the yields.
What are the costs associated with defeasance in apartment loans?
The main costs associated with defeasance in apartment loans come down to the complexity of the process and the capital investment into the replacement collateral. According to Apartment.loans, the process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully. This time factor can make the process itself prohibitively expensive. Additionally, the capital investment into the replacement collateral — the bonds — used to offset the yields can also increase the costs of defeasance.
How does defeasance affect the terms of a commercial real estate loan?
Defeasance can be highly beneficial to borrowers, as it involves the substitution of a riskier asset (a commercial real estate loan) with a much safer asset (typically U.S. Treasury bonds). This can help borrowers get out of a loan early, freeing up their capital for investment opportunities that may generate a higher yield than their original commercial property. For the lender, defeasance is also generally a good thing, as it removes any risk of repayment and replaces it with returns guaranteed by U.S. Treasury bonds (or, in some cases, bonds issued by Fannie Mae, Freddie Mac, or Ginnie Mae).
Defeasance can also have accounting benefits. By replacing the collateral with securities, the debt is effectively removed from a company’s balance sheet. This makes a commercial real estate investor’s books far less complex when it comes to logging debt service transactions.
Just like a commercial or multifamily real estate investor involved in litigation would generally rather hire a lawyer than representing themselves in court, most borrowers who want to defease their loan will generally hire a defeasance consultant to conduct the entire process for them. While the concept may sound simple, defeasance, overall, can be somewhat complex. The exact amount of bonds must be purchased, secured in the proper way (typically a custodial account), and recorded and filed property for tax purposes. In addition, a certain amount of negotiation and communication with the lender will typically be required throughout the entire process.