In the fast-moving commercial real estate market, with its constant demand for new products and innovative ideas, the creation of the defeasance market opened up a new venue for medium-risk investors. By enabling borrowers to take out loans while protecting their real estate, defeasance experts are ensuring the borrower a manageable source of loan capital without incurring too much of a tangible risk.
Defeasance is a collateral substitution process that releases the borrower from obligations associated with its debt through the replacement of preexisting collateral with a portfolio of high-quality bonds.
This initial collateral is usually in the form of mortgaged real estate, and is replaced by secure bonds, generally U.S. Treasury Securities, which are called defeasance collateral. The cashflow generated by the portfolio secures the debt and meets future obligations of the original transaction.
The defeasance process benefits all parties involved in a classic loan transaction. Historically, loan originators used fixed-rate commercial mortgage-backed securities (CMBS) to securitize their loans, but unreliability in the interest rates and property value often posed a high risk for lenders – reducing the value of the loan.
As a result, since 1998, most CMBS loan documents have a clause that imposes defeasance provisions on the borrower. Defeasance solves the issue of a potential prepaid loan before its stated maturity by transferring the collateral from something with high-risk potential to a more stable bond.
On the borrower's side, the fees incurred when the borrower decides to prepay a loan before its stated maturity make it less economically desirable to refinance the loan and inhibit any increases in inherent value.
By replacing the original real estate collateral with an independently performing portfolio, however, the borrower is then released from the loan responsibilities, able to freely participate in the real estate market without absorbing penalties or risks.
The conceptually simple procedure of defeasance requires a complex process of legal documentation and involvement with third parties – imposing a heavy financial burden on the borrower. By managing the transaction and providing consulting on the entire process, defeasance facilitators can provide a series of individualized services, making their inclusion in the process both essential and financially redeeming.
Inside the transaction
Some of the key players involved in a typical defeasance transaction include the initial borrower, the loan service provider, attorneys, accountants, rating agencies, a securities intermediary, the title company and the refinance lender or the successor borrower. In addition, the presence of a defeasance consultant can ensure cooperation from all the other participatory parties.
While the entire defeasance process usually takes about 30 to 40 days, under prime conditions, the transaction can take place within a single week. Timing varies based on the complexity of the loan, the motivation of the borrower, assessment of the trade securities, and the ease of conversation among involved parties.
Defeasance transactions proceed on a strict three-day closing process. Day one is focused on the purchase of the securities. By the morning of day one, all associated transactions and defeasance documents must be completed and signed. This paperwork includes any sale or refinance of the real estate involved and any other transactions that may take place in connection with the defeasance.
At the close of day one, the securities service council identifies and purchases the securities on behalf of the initial borrower. Day two involves the accountants: After confirming the physical receipt of the securities purchased the day before, the accountants provide the necessary verification to the title company to move on to day three.
Day three represents the final conclusion. On the morning of day three, the securities purchased and verified are transferred to the securities intermediary and the successor borrower. Upon receipt of these securities, the custodian becomes responsible for holding the securities and ensuring proper payment for the rest of the time until the loan matures.
Once all the fees are wired to their appropriate destinations and participatory parties, the loan servicer will authorize the release of the previous collateral – the mortgage of the real estate – back into the hands of the initial borrower by the end of day three.
New trends
Because CMBS loans are dependent on real estate, the cyclic nature of the real estate industry has a direct impact on the defeasance market. In recent months, a slowdown in the CMBS market played a critical role in the quiet of the current defeasance market area.
However, as the real estate market rebounds and trends shift, the CMBS market – and consequentially, the defeasance sector – will produce stronger numbers than past fiscal years.
Economists have previously criticized the defeasance industry for the lack of market creativity. As the concept was born out of the need for a solution to the high-risk fixed CMBS loans, it was initially treated as simply a loan servicing industry.
The growing popularity and expansion in the defeasance market, though, has created the need for participants to specialize and individualize, increasing the level of creativity.
Moving away from the loan service industry and into the open marketplace as a capital markets industry business, key players have adopted a manner of behavior that promotes innovation and development, constantly adding to a more efficient marketplace.
Part of this recently developed creativity was the introduction of new opportunities for the borrower to reap additional benefits from the transaction. Over the last several months, the industry has adopted the practice of sharing the residual value of the matured loan between the lender and initial borrower.
Monetizing the borrower's residual value at the time of the defeasance allows the borrower to reap the benefits of the residual value before the loan's maturity.
Another emerging innovation concerns the traditional three-day closing process. Due to structural changes within the participatory parties and an increase in the document preparation preceding the closing process, what was once an industry standard three-day process has more commonly been completed in two.
Further changes and higher levels of proficiency have made the one-day closing process – initially deemed impossible – a more tangible reality.
With the implementation of the process that allows the borrower to absorb residual value of the securities before the maturity of the loans, heightened focus on maximizing the profitability of the defeasance process for the borrower has led to discussions of different options.
One option that the industry is looking to adopt in the near future is to grant the borrower more control of the defeased loans after the transaction is complete. This increase in control and responsibility will result in the ability of the borrower to benefit from financial windfalls even after the loan has been defeased.
In addition, although the defeasance market had traditionally been focused on CMBS loans, the growing market has come to include other types of companies in the process. Lenders like life insurance companies and traditional portfolio lenders have caught onto the increasing trend and have begun to adapt defeasance language to their loan documents.
Along the same lines, with the defeasance market's growing popularity and expanded economic importance, more diverse companies are joining in. Recently, Novogradac, a nationally recognized CPA firm, entered into the small arena of defeasance accountants.
As the market continues to expand, new opportunities for successor borrowers and service providers will help boost the competition in the industry and challenge existing institutions to come up with more profitable, innovative options for borrowers and lenders alike.
Stewart Wolmark is president of Reliable Defeasance LLC, a Beverly Hills, Calif.-based commercial mortgage defeasance firm. Eric Ridel is business development manager at the company. Ridel can be contacted at (310) 728-1123 or ericr@reliabledefeasance.com.
