DEFEASANCE? HOLD MY BEER.
I give my client a moment to think, and then repeat myself. “The lender’s real estate collateral will be replaced with a cocktail of securities, the collective returns of which will mimic the borrower’s repayment obligations as if the debt had not been defeased.”
Explaining the process, sequencing and business considerations of defeasance to anyone new to the world of securitized debt is an interesting experience. Why? Because nothing about defeasance is intuitive. Very smart people can have a hard time absorbing the mechanics of defeasing debt and the interplay among the cast of involved parties. This is my attempt to demystify defeasance.
SECURITIZED LENDING – A PRIMER
In traditional commercial real estate lending, the promissory note sits in the bank’s safe from the date of closing until the indebtedness is paid off. People in the commercial real estate industry refer to these as ‘balance sheet loans’, because they stay on the balance sheet of the bank. By comparison, fixed-rate CMBS loans and Fannie Mae/Freddie Mac apartment building loans can be ‘securitized’. In the world of securitized debt, loans with particular characteristics are bundled together, rated by Standard and Poor’s or another credit rating agency, and ultimately sold to a roster of certificate holders (usually ETFs, pension funds, sovereign wealth funds and other institutional investors).
It is important to note that certificate holders are ‘just money’ investors who lack the administrative apparatus to service the debt. So, from the closing date on, a servicer (often an affiliate of a recognizable financial institution) is designated to act for the certificate holders in all respects. Who does the property owner call if there is a fire at the property? The servicer. Who is notified when the property owner wants to put an addition on their building? The servicer. Who is bound to strictly interpret and follow the terms of the loan documents on behalf of the certificate holders (often to the chagrin of the property owner)? You guessed it. The servicer.
WHY DEFEASANCE? LET ME EXPLAIN WITH AN ANALOGY
There are two primary reasons for a property owner to defease its securitized debt: (1) to sell the collateral real estate or (2) to refinance. Well, you might ask, why can’t the property owner simply prepay the debt as it would with a balance sheet loan? The answer is that traditional prepayment is not permitted because certificate holders demand payment and yield certainty on their investment. A conventional prepayment model would disrupt the payment stream flowing to the certificate holders.
So, in the world of securitized debt, the straightforward, ‘terrestrial’ concept of prepayment is replaced with defeasance, a more complicated, multi-step process indicative of the ongoing ‘Wall Streetification’ of commercial real estate. The best way that I can explain defeasance is to retell a conversation that I’ve had with clients when I know that they don’t really understand.
“What are all these opaque defeasance fees showing up on the draft closing statement? They add up to a lot of money!” “Well,” I respond, “have you ever traveled to a third world country? No? Well, after you get off the plane in a third world country, you go to the baggage carousel to collect your luggage. When you do, an official-looking man in uniform sticks out his hand and says that you owe a luggage fee of $20 (US dollars, of course!) per bag. You roll your eyes and pay him. And he puts your money in his pocket. Then, at customs, somebody else demands $100 as an ‘entry fee’. The guy next to him says you must pay a $50 tourism fee and – smiling broadly – he says that if you don’t pay up, he’ll keep your passport. They’re all in uniform. They’re all part of the ‘official process’. You won’t enjoy paying them, but that is the cost of visiting that third world country. Defeasing debt is no different. A battery of servicers, consultants, accountants and counsel are getting paid to enable you – as the property owner – to release the existing mortgage lien on your property so that you can refinance or sell your property.”
A MECHANICAL OVERVIEW; SEQUENCING
OK, so if you’ve made it this far, you have a general sense of defeasance. Now, let’s go ‘next level’ with some details.
In a defeasance context, the property owner is referred to as the original borrower, to differentiate from the unaffiliated successor borrower that will be formed to assume obligations under the existing loan documents from the time of the defeasance closing onward.
The original borrower is typically forbidden from paying off the mortgage debt for a period of 2 years following securitization. Once this lockout period ends, the original borrower can trigger defeasance by notifying the servicer of its intent to defease and paying a non-refundable deposit. At this point, the original borrower needs to retain counsel to represent it and select a defeasance consultant.
The servicer’s counsel will draft a set of defeasance documents which are ‘standard’ from deal to deal, but are negotiable in certain key areas. Of particular importance is the release which protects the original borrower after the defeasance closes (more on that later). The defeasance documents will also be reviewed by counsel for the successor borrower.
Unlike most modern real estate closings, which are planned to close in one day, defeasance closings are typically spread over a period of two days. Once the defeasance documents are finalized and the original borrower is ready to close the refinance or sale of the property (as applicable), the original borrower will give its authorization for the replacement collateral securities to be ‘circled’ (identified and committed to be purchased) on Day 1 of the closing. On Day 2 (the following business day) the original borrower is obligated to purchase the circled securities and close the defeasance transaction. Critically, the lien encumbering the real estate collateral will be released on Day 2, enabling the defeasance closing to be synchronized with the closing of the corresponding refinance or sale of the property. This requires significant coordination among all involved parties and their counsel.
OH, THE RELEASE!
After the original borrower refinances or sells their property, the successor borrower assumes obligations with respect to the underlying loan, and the indebtedness due to the lender lives on. This keeps in place the payment obligations under the existing Note, which is of great importance to the certificate holders. To insulate itself against loan defaults occurring after defeasance, the original borrower negotiates for a release from future claims, liabilities and obligations related to the underlying loan. This release is embedded within the defeasance documents.
DEFEASANCE IN SUMMARY
To the uninitiated, defeasance may seem overwhelming and expensive. However, in the right context, defeasing securitized debt can be an intelligent, financially advantageous exercise for the property owner looking to take advantage of attractive refinancing terms or a high purchase offer. As with any sophisticated financial transaction, experienced representatives are needed to navigate the defeasance process.
As part of his commercial real estate practice, Andrew Maguire, Esq. has represented clients in numerous successful defeasance transactions. You can reach him directly at 610-341-1032 and amaguire@mkbattorneys.com.
Please note that this writing does not constitute legal advice, and that reading it does not create an attorney-client relationship with McCausland Keen + Buckman.