Commercial Investment Real Estate July/August 2016

BREAKING DOWN DEFEASANCE CMBS borrowers should understand the prepayment process. During the last cycle, commercial mortgage backed securi- ties lending gained in popularity, culminating in a frantic pace of origination between 2005 and 2008. During that period, many borrowers went through loan defeasance. But for a fairly long stretch of time following the CMBS market implosion, the economics of defeasance rarely made sense. However, with rates still near historic lows and commercial real estate prices favorable to sellers, many more loans will enter into defeasance over the next several years. Th is article discusses what borrowers should know if they are consid- ering defeasance, and why they should ask for defeasance prepayment provisions in a new loan. What Is Defeasance? Defeasance is the standard CMBS industry alternative to traditional prepayment penalties such as the yield main- tenance penalty common to life insurance company loans and fi xed percentage penalties common to local bank loans. Rather than being a true prepayment, defeasance is the sub- stitution of securities collateral for real estate collateral. Th is allows a release of the property lien, freeing the asset for refi nancing or sale. A borrower’s property is released when a portfolio of U.S. government securities is structured to replace the cash fl ow covering the debt service. A special purpose entity, known as the successor borrower, assumes the role of the borrower and makes payments on the loan using the portfolio of securities. Th e complexity and upfront costs of loan defeasance can be intimidating, and the intri- cate process has oft en led to an uneven playing fi eld. by Thomas Welch and John Poole  July | August | 2016 Given a choice, most borrowers would prefer yield mainte- nance or fi xed percentage prepayment penalties to defea- sance. However, variations to defeasance are uncommon and require spread premiums if elected in a CMBS fi nanc- ing. Yield maintenance, though it requires careful math to estimate accurately, is simple enough to calculate, and fi xed percentage penalties are even simpler. Due to the opaque nature of defeasance, defi ning it up front and calculating when implementing it requires borrowers to seek good advice and demand transparency. Using a qualifi ed inter- mediary can help. Using an intermediary has several advantages over relying on an online defeasance calculator. Most notably, it provides reliability through a review of replacement collateral require- ments and the defeasance duration period. For example, cer- tain CMBS loans provide a choice between defeasance and yield maintenance, or allow borrowers to substitute replace- ment securities that off er a higher yield than Treasury instru- ments. In short, borrowers have the opportunity to confi rm what their true prepayment situation is. When it comes time to initiate defeasance, transparency Commercial Investment Real Estate Leveling the Playing Field

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