Defeasance as a Prepayment Penalty for Conduit Loans
CMBS loans have a variety of upsides for borrowers, including low, fixed interest rates, lenient net worth requirements, and the fact that they’re non-recourse. However, one major downside of CMBS is the strict prepayment penalties that these loans carry with them.
Unlike banks, which often carry loans on their balance sheets, CMBS loans are pooled, securitized, and purchased by investors on the secondary market, which requires borrowers to ensure that the investors receive the same amount of income as if the loan had been paid to maturity. That means prepayment penalties can be hefty.
Defeasance is generally the most common type of CMBS prepayment penalty. Unlike percentage-based prepayment penalties, a borrower needs to replace their CMBS loan’s collateral with new securities, typically U.S. Treasury bonds in order to replace CMBS investors’ income. The defeasance requirements for an individual CMBS loan are generally detailed in the defeasance clause of the loan’s pooling and servicing agreement (PSA).
In some situations, another prepayment method, yield maintenance is allowed. Sometimes, borrowers can choose between the two during the closing process, or even at the point of prepayment.
Defeasnce in Practice: What Borrowers Need to Know
Defeasance requires a series of specific legal and financial transactions, which means that most CMBS borrowers hire a defeasance consultant in order to complete the process for them. The consultant will often utilize lawyers, accountants, broker-dealers, and a specialized intermediary in order to calculate the number of bonds needed, purchase them, and place them in a special escrow account that will make the required principal and interest payments to the CMBS REMIC (real estate mortgage investment conduit), and hence, the CMBS investors.
Defeasance vs. Yield Maintenence
The cost of defeasance generally depends upon the current interest rates for Treasury bonds. When interest rates on bonds are lower than the interest rate of their CMBS loan, defeasance becomes more expensive, as a borrower will need to purchase more bonds (even more than the remaining principal on their loan) in order to generate the same interest income. This spread between the conduit loan interest rate and the interest rate of the substitute bonds is referred to as a defeasance premium.
In contrast, when interest rates on the substituted securities are higher, particularly if they are higher than the interest rate on the CMBS loan, defeasance is less expensive, as the borrower will need to purchase fewer bonds to make up for investors’ income. In theory, a borrower could actually make money during this process. Income gained during defeasance is referred to as residual value.
While gaining residual value is ideal for borrowers prepaying a loan, it is often offset due to the high cost of the defeasance process, due to the fact that the combined cost of lawyers, accountants, and defeasance consultants can often add up to between 10% to 30% of the entire unpaid principal balance (UPB) of the loan. However, if a borrower is smart and chooses a great defeasance consultant, it’s not unheard of for them to leave the transaction with money in their pocket.
In contrast to defeasance, yield maintenance actually involves the repayment of the loan, in full, in addition to all the interest income that the CMBS investors would have gained if the loan were paid up to its maturity date. Yield maintenance will also typically involve paying a small fee to the loan’s servicer.
Therefore, when choosing between defeasance and yield maintenance, defeasance is typically a better choice when interest rates are high, as well as when a CMBS loan’s pooling and servicing agreement permits the borrower to use agency bonds, such as Fannie Mae or Freddie Mac bonds, as replacement collateral. As these bonds have higher interest rates than Treasury bonds, less bond collateral is needed, making the defeasance process less expensive.
CMBS Prepayments and Loan Assumption
In some cases, a borrower looking to sell a property and prepay their CMBS loan before its maturity date may want to find a buyer who is willing to assume, or take on, the existing loan. This would prevent the existing borrower from having to pay prepayment penalties. In most cases, CMBS loans can be assumed with servicer approval and a small fee, often around 1%. Therefore, assuming a loan prevents the new borrower from having to pay expensive origination fees and lender legal fees, which generally start at $10,000 to $15,000 for newly originated loans.
If interest rates have risen and the CMBS loan has an interest rate lower than the current market rate, assuming the loan may be ideal for the new borrower. In contrast, if the current CMBS interest rates are lower than the interest rate of the existing loan, a new borrower may not want to assume it. The remaining LTV of the loan is also an important factor; for instance, if the existing borrower has paid down the loan to 50% LTV, a new borrower may not be interested in taking on a loan with so little leverage.
While the new borrower may be able to take on mezzanine debt or preferred equity in order to boost their leverage, these options can be more expensive than taking out a new CMBS loan in the first place.
Therefore, an existing borrower is only likely to be able to convince a new buyer to assume their loan under favorable conditions.
The requirements for the assuming borrower are generally the same as the requirements for the initial borrower; documentation like credit checks, borrower net worth documentation (which typically must be around 25%+ of the unpaid principal balance or UPB of the loan), borrower bios, and schedules of real estate owned (SREOs), which detail any other real estate the new borrower owns, are generally required.
Unlike getting a brand new CMBS loan, the only third-party report that is generally required is a property condition assessment (PCA) which helps to ensure the property has remained in good condition and is still good collateral for the loan.