Commercial Investment Real Estate July/August 2016 | Page 25

becomes even more important. Are the replacement securi- ties optimized for the borrower? Are the transaction costs fair? Is the borrower the beneficiary of the value of the successor borrower? Borrowers should think about this. Most loans have a 30- to 180-day open prepayment window, but most older loan doc- uments require the borrower to buy replacement securities through loan maturity. If the successor borrower later repays the loan at the beginning of the open prepayment window, it will reap a windfall. Will the borrower participate in that windfall when it happens or be off ered a present value share of that value at the time of defeasance? Simply put, understand that two variables — the reduction of the remaining loan term and increased replacement securi- ties yields — decrease the cost of defeasance. One of the fun- damental benefi ts of defeasance is the fl exibility to refi nance the property at current low rates. Like yield maintenance, the present value of remaining interest payments generally repre- sents the largest component of defeasance cost. Th e most obvious risks in deferring a refi nance until the open period are the possibility of a higher interest rate and the maturity risk from refi nancing in less liquid future capital markets. Th erefore, if a qualifi ed intermediary has modeled the loan defeasance, the borrower can monitor rates, capital market conditions, and defeasance costs in real time to better react at an optimal point in time. For many borrowers, that optimal point in time comes 12 to 18 months prior to loan maturity. Still others employ alter- native strategies, such as a forward loan rate lock to reduce or eliminate prepayment costs, or a sale with assumption of the debt as a way to avoid defeasance. Also, the prepaid interest component of defeasance may be tax deductible, something borrowers should discuss with their tax professional as a part of an overall portfolio strategy. Ultimately, deferring a refi - nance in a rising rate environment means borrowers this year could lose out by waiting until 2017 or 2018 to refi nance. Reducing Defeasance Costs When fi nancing a property with CMBS debt, borrowers should attempt to negotiate several favorable defeasance pro- visions. For example, they should defi ne defeasance collat- eral to include not only U.S. Treasuries but also other agency securities that may have a higher yield. Th ey should seek the right to designate the successor borrower. If possible, they should secure the right to loan defeasance only through the start of an open period as opposed to through maturity. Also they should ask for the rights to deliver securities instead of cash to the lender for their purchase, cap servicer defeasance fees, and choose between defeasance and yield maintenance. Defeasance can be a powerful tool in today’s low interest rate market. While the defeasance cost will decrease over time to zero, rising interest rates will make new debt more expensive and reduce cash fl ow aft er debt service. Using an CCIM.com experienced mortgage broker who works with a qualifi ed defeasance intermediary can help to take advantage of the available refi nance opportunities. Does Defeasance Make Sense? Th e decision to use defeasance to refi nance depends on sev- eral factors, but the fi nancial analysis aspect is relatively straightforward. For example, in 2007, Colliers originated a $12 million loan with a term of 10 years, an amortization of 30 years, and an interest rate of 5.75 percent. Th e annual debt service was approximately $840,000, with a remaining loan balance of approximately $10,350,000 at the time of refi nanc- ing, 8.5 years into the loan term. Defeasance and refi nancing transactions costs totaled slightly more than $950,000. Colliers obtained competitive bids for a new loan sized to 100 percent of refi nancing costs, and recommended a nonrecourse option with a 10-year fi xed rate of 4.50 percent, amortized over 30 years and new annual debt service of approximately $690,000. Th is resulted in an increase in pre-tax net cash fl ow of $150,000 to the borrower. Additionally, the client’s tax pro- fessional advised that a signifi cant portion of the defeasance costs and transactions fees would provide valuable tax benefi ts to the client. Between the reduction in debt service and the value of tax deductions, the time to recoup cost was relatively short. Moreover, given that the borrower could refi nance to a lower rate with no cash out of pocket and eliminate both refi nance risk in 18 months and interest rate risk for 10 years, defeasance and refi nancing made sense. Sometimes defeasance is not feasible. A loan may be locked out from prepayment, deals with longer remaining terms may be simply too expensive to refi nance. On the other hand, borrowers oft en choose to defer defea- sance for loans with less than 12 months remaining until the open period or maturity. In this scenario, Colliers has used forward rate commitments with insurance companies and banks to rate lock for up to 12 months in advance of refi - nancing to signifi cantly reduce defeasance costs or eliminate them altogether. In summary, borrowers who have loans with defeasance provisions should have a qualifi ed party model defeasance based on the specifi c loan document provisions now. Even if it is not feasible to use loan defeasance now, borrowers should request periodic real-time updates of the defeasance cost. If borrowers are 12 to 24 months from maturity or open pre- payment period, they are likely close to the sweet spot for refi nancing to a lower rate. Such preparation now will better position borrowers to move quickly when they determine the time is right. Thomas Welch is senior vice president and John Poole is an associate of the capital markets team at Colliers International in Boston. Contact them at [email protected] and John. [email protected]. July | August | 2016 