Defeasance Definition, Explanation, and Comparison to Other Prepayment Options
When paying off a commercial or multifamily loan early in order to sell or refinance the property, a borrower will generally need to compensate the lender in the form of a prepayment penalty for their loss in income. Defeasance is one of the most common types of prepayment penalties available. Defeasance involves purchasing income-producing bonds to replace the income the lender loses from the borrower prepaying the loan.
What Types of Loans Require Defeasance?
Defeasance is most common for loans that are securitized. When a loan is securitized, it is packaged, or pooled, with other similar loans to create a bond that is sold on the secondary market. Common types of loans that are securitized into bonds include CMBS or conduit loans, Fannie Mae multifamily loans, and Freddie Mac multifamily loans.
Defeasance is usually achieved by purchasing government bonds with a similar term and interest rate as the original loan. In most situations, this will involve the purchase of U.S. Treasuries or other government-backed bonds but could involve the purchase of highly-rated (think AAA) private bonds. Usually, these bonds are less risky than the original debt provided to the real estate borrower, which is beneficial to the lender, as it reduces their risk profile.
Sometimes, lenders require a loan to be defeased through the entire loan term, while in other cases, the required defeasance period is substantially shorter. In general, fixed-rate loans often require defeasance, while variable-rate loans do not.
How Can Borrowers Conduct Defeasance on Their Loans?
In most cases, a borrower will hire an expert defeasance consultant to conduct the defeasance process on their behalf. While, in theory, a borrower could do the process themselves, it would require expertise and resources that the average real estate investor or investment firm simply does not have.
First, a defeasance expert will calculate the exact type and amount of bonds that are needed to replace the lender’s income. Then, the bonds will be transferred to a specially created special-purpose entity, which acts like an escrow account, which is controlled by a securities custodian referred to as a special intermediary.
The special intermediary will send the bond income on a monthly basis to the lender (or the loan servicer) in order to replace the lender’s income. In most cases, an accountant is also required to audit the bonds to ensure they will provide sufficient income at an acceptable risk profile for the lender. A rating agency may also be required to further calculate the risk profile of the bonds to ensure they do not increase the risk of the securities pool. This process may take up to 10 additional days.
In addition, both the borrower, the loan servicer, and the successor borrower will generally need to hire attorneys to conduct the process smoothly.
How Long Does The Defeasance Process Take?
Defeasance timelines can vary due to factors including the lender’s demands, covenants on the loan agreement, and the time it takes the defeasance consultant to arrange the entire process. Most lenders require at least 30 days’ notice of defeasance, with some requiring longer time periods. In most cases, the entire process can take as little as 40 days.
What is Residual Value?
In some cases, the bonds purchased by the defeasance consultant will actually generate more money than is needed to repay the lender. This is referred to as residual value. This usually occurs when market interest rates are higher than the interest rate of the loan itself.
After the loan is fully paid off, any additional bonds remaining will be sold by the successor borrower entity, which will generally transfer these funds back to the original borrower/investor.
Defeasance vs. Other Prepayment Penalties: What’s The Difference?
Other common prepayment penalties for commercial and multfiamily loans include yield maintenance, and step downs. Yield maintenance, which is somewhat more common than defesancce, requires that borrowers pay the rate of difference between the current interest rate on the loan and the current market interest rate on the remaining part of the loan.
Yield maintenance can be calculated via the below formula:
Yield Maintenance = Present Value of Remaining Payments on the Mortgage x (Interest Rate - Treasury Yield)
Yield maintenance is usually a better financial choice for borrowers if:
The overall prepayment amount is smaller
Payments are measured to the loan’s prepayment date
Bond interest rates are compounded annually
In comparison, defeasance is often better when:
The overall prepayment amount is larger
Payments are measured to the loan’s maturity date
Bond interest rates are compounded monthly
In contrast to yield maintenance and defeasance, step-downs involve a set percentage of the remaining loan amount which must be paid to compensate the lender. For instance, a loan could have a step down of 5% for the first two years, 4% for the next two years, 3% for the following year, and 2% for the remaining life of the loan. Many loans will also have a lock-out period of 1-2 years in which the borrower is not allowed to repay the loan at all.
All of this means that commercial and multifamily borrowers should be highly aware of the prepayment penalties on the loans they take out. This is especially the case for longer-term loans (think 10-year+), in which a borrower is far more likely to sell or refinance the property (and thus incur the prepayment period) before the loan term is complete.