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Defeasance in a Volatile Market

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Defeasance in a Volatile Market

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The idea behind defeasance emerged in 1970s in the municipal bond market. However, it became quite popular in the industry in the 1990s. Almost all fixed-rate commercial real estate loans established in the last one and half decade require borrowers to defease the loans in order to refinance or sell. The term defeasance simply refers to the substitution of collateral. Specifically, the borrower is required to provide substitute collateral that will generate proceeds that are sufficient to pay the interest rate due and the remaining principal amount. In the US commercial mortgage finance industry, borrowers are required to provide substitute collateral in the form of government securities.

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Demand for new loans has been accelerating over the last one decade fuelled by the rising property values and attractive interest rates. Due to the increased market volatility in the recent years, most of these loans are required to be securitized. This explains the fact that commercial mortgage backed securities (CMBS) have become quite common in the past one decade. One typical feature of most CMBS loans is that they have restriction on prepayment. Generally, the documents used to obtain CMBS loans prohibit prepayment except for short periods towards the end of the loan term. The borrowers of securitized loans are left with limited options for exit. Loan defeasance is one of the options that are offered to borrowers of commercial real estate loans.

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Defeasance is a clause that is included in a commercial mortgage agreement that gives the borrower of commercial mortgage loan the right to redeem the property upon full payment of the principal amount and interest due. The clause allows the borrower to pay off the loan earlier than scheduled. Thus, the borrower can save on interest costs without incurring a penalty from commercial mortgage bankers for early termination of the loan. However, I have realized that it is essential for mortgagers to seek advice and essential information from consultants, commercial mortgage bankers and real estate investment trusts before engaging in the transaction. This is due to the fact that there are numerous costs involved. In particular, the mortgager will incur a cost of obtaining defeasance securities and the cost of paying parties such as consultants, the refinance lender, specialized consultant, securities intermediary, loan servicer and attorneys.

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