TransacTional real esTaTe The Role of Defeasance In Real Estate Finance

Abstract

efeasance is now a common feature of real estate finance, allowing a borrower to effectively prepay a loan that is not by its terms prepayable. A defeasance is a substitution of a loan’s real estate collateral with collateral consisting of securities—thus freeing up the real estate in order that it may be sold or refinanced—and a corresponding substitution of a new borrower for the original borrower. Defeasance is often seen in commercial mortgagebacked securities (CMBS) loans, in large part because of restrictions on prepayment of such loans that arise under the statutory scheme governing the real estate mortgage investment conduits (REMICs) used to package these loans for sale to investors. As a general matter, prepayment restrictions and penalties protect lenders from borrowers’ prepaying their loans whenever interest rates go down (which would likewise force lenders to reinvest the prepayment funds at the then lower interest rate). Prepayment penalties can take a variety of forms, including amounts based on a simple percentage of the principal being prepaid and yield maintenance premiums based on the differential between the interest that would have been received by the lender on the amount being prepaid and the interest that would be earned on specified investments if the amount being prepaid were used to purchase such investments. Prepayment restrictions in the CMBS context raise a special set of issues because (i) the tax code restricts how and when prepayments can be made on CMBS loans and (ii) prepayment disproportionately affects certain categories of CMBS investors. As a consequence of these factors, defeasance has become the preferred method of addressing prepayment in CMBS loans. In a defeasance, refinancing or sale proceeds or other cash amounts are used to purchase substitute collateral for the mortgage loan (which survives and is secured by the substitute collateral). This protects the economic expectations of the CMBS investors while allowing the borrower the flexibility to sell and/or refinance its property free of the mortgage loan. Because interest rates have been at historic lows for some time now, any borrower in a position to refinance has likely done so already in anticipation of the inevitable and predicted swell in interest rates. For the time being, defeasance is most likely to arise in the context of a property disposition or when a borrower seeks to tap into property equity through a cash-out refinancing. The substitute collateral in a defeasance consists of a “basket” of U.S government securities purchased by the existing borrower and assigned to a newly formed, unaffiliated successor borrower. These securities are selected to produce a monthly payment stream that replicates what the existing borrower would have paid in monthly debt service for the remaining term of the loan. The successor borrower (i) assumes most of the existing borrower’s obligations under the loan (though the existing borrower generally retains certain liabilities relating to the formerly mortgaged property or the defeasance itself,—e.g., the obligation to indemnify the lender for environmental matters that survive repayment or potential liabilities arising under representations relating to the defeasance) and (ii) pledges the securities as collateral for the assumed debt. When the security interest in the new collateral is granted, the existing borrower’s real property is released Volume 254—No. 4 WedNesday, july 8, 2015