Defeasance: An alternative way to refinance a commercial loan
What is defeasance?
- Defeasance is an alternate way to refinance a commercial loan
- Defeased loans can offset the cost of prepayment penalties
- It’s a complicated bond process that generally requires financial expertise
Commercial loans differ from the typical home loan. One of the major differences revolves around the rules of paying off a commercial loan early or refinancing it.
As with home loans, a commercial building owner may want to refinance a loan or sell the property serving as collateral. With a home loan, this is relatively easy. Loans for commercial real estate can be tricky, however.
Many commercial loans carry stiff prepayment penalties that can limit when, or even if, it is possible to get out of the loan before the full term expires. This is usually the case when the loans are used to back securities that are sold investors, who are expecting a fixed return over a specified time on their investment. The early payment penalty for many securitized commercial loans can run between 1 percent and 3 percent of the mortgage balance.
What is defeasance?
One way around the prepayment penalty is a process known as defeasance. With defeasance, the borrower purchases a portfolio of government securities, normally U.S. Treasurys, which are then substituted as collateral in place of the property originally pledged as collateral for the commercial mortgage. The portfolio is set up to ensure the pledged payments to the bondholders continue.
Once the government-securities portfolio is in place, a new entity is established to assume the obligations to the bondholders, who will continue to be paid the agreed-upon rate via the proceeds from the new bond portfolio — thus freeing up the property that was originally pledged as collateral for the loan. Once the obligations to the bondholders are met, the cost of purchasing the government securities can be offset through the proceeds from the sale of those government securities.
Defeasance structures are complicated to set up and can be expensive. The borrower typically needs to employ a team of financial professionals to complete the transaction and manage it afterward. It is not a process that you will be able to take on without a dedicated financial team’s assistance. A number of companies specialize in defeasance services. The fees for the process are typically in the $50,000 to $100,000 range, depending on the complexity of the transaction.
There are limitations to when you can defease a loan. There is a mandatory lock-out period. A loan typically can’t be defeased until two years have passed after it has been securitized, or for up to four years from the point when it was first originated by a lender.
Costs vs. benefits
Defeasance has its advantages. On large commercial loans, borrowers can realize a net savings in the hundreds of thousands of dollars in loan-interest charges if they can refinance into a significantly lower interest rate, absent the prepayment penalty. Defeasance also is an alternative way for a borrower to free up property originally pledged as collateral in order to sell that property.
The borrower needs to balance the cost associated with defeasance against the costs of alternative courses of action, including choosing to do nothing. The cost to defease is tied to the cost of U.S. Treasurys. As Treasury costs rise, costs to defease also increase.
The defeasance cost should be viewed as a penalty for altering the loan-obligation terms, and should be weighed against the cost of the early prepayment penalty that would be incurred if the original mortgage is refinanced at a lower rate or extinguished through the sale of the property used to secure that mortgage.