How do I know if my loan is eligible for a defeasance?
The team at Capital Defeasance Group can check your loan documentation to determine what type of prepayment provisions your loan documents specify. Most conduit, or CMBS, loans issued since 1998 require a defeasance to substitute security collateral for the loan and release the borrower from loan obligations.
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What is the legal definition of defeasance?
Black’s Law Dictionary (8th ed. 2004) defines defeasance as “A condition upon the fulfillment of which a deed or other instrument is defeated or made void; a contractual provision containing such a condition.” For conduit loans, the “condition” is the substitution of collateral with government securities and the “deed” is the original lien on the borrower’s property.
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What is the history of defeasance?
Most commercial real estate loans including conduit loans and CMBS loans have prepayment protection. The prepayment requirements exist to protect the lenders and CMBS investors and act as a form of call protection similar to what exists for corporate bonds.
There are three main types of prepayment mechanisms: declining balance, yield maintenance, and defeasance. Defeasance became increasingly used with conduit loans in the mid-1990s. By the late 1990s, defeasance became the predominant prepayment requirement, representing about 80% of loans issued in 1998 and over 90% of loans issued from 1999 through today.
Other forms of prepayment protection
Declining balance is the oldest and simplest prepayment penalty, structured as a percentage of the outstanding balance that declines as the loan nears maturity. Prepayment of the loan is allowed, but amounts to the principal outstanding plus the penalty. For example, the loan might allow no prepayment until five years have passed since origination (termed the “lock-out” period). After that, the borrower could prepay the balance, incurring a penalty of 5% of principal balance anytime during the fifth year before maturity, declining to 4% in the fourth year, 3% in the third year, and so on.
Yield maintenance became popular in the 1990s, because declining balance penalties are fixed and are not linked to any yield foregone by the lender. Yield maintenance allows the lender to calculate the present value of any interest payments foregone with a prepayment. The goal of yield maintenance was to provide the lender a lump sum that when reinvested in U.S. Treasury securities would yield the same return as if the original loan was paid until maturity. Unfortunately, yield maintenance provisions allow the lender to make a practically indisputable calculation of the prepayment amount and therefore determine the lump sum payment. For conduit loan investors, and particularly investors who buy the interest-only securities, these premature principal payments were still undesirable.
A defeasance transaction is a prepayment from the borrower’s perspective. Although the loan remains in place, nearly all of the original borrowers’ rights and obligations are assumed by shifting the loan to the Successor Borrower. (read more on Successor Borrower) From the securitized loan pool’s perspective, defeasance improves the credit profile of the loan pool by substituting lower risk collateral for the original real estate. From the perspective of the investors and the agencies rating the CMBS certificates, defeasance is beneficial because it significantly reduces default risk. The substitute collateral consists of government securities that the Succesor Borrower cannot liquidate and from which loan payments are made directly. As more loans in a securitization trust are defeased the credit rating of the CMBS securities are often upgraded.
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How does defeasance differ from yield maintenance?
Defeasance and yield maintenance share some similarities but many differences. Defeasance is relatively standardized regarding terms and requirements, but yield maintenance language has not been standardized and the payment may be inflated as a result of conflict and confusion.
While both are similar from a financial perspective, they are almost direct opposites from a legal perspective. Financially, both are designed to give the lender a guaranteed yield equivalent to what would have been received if the loan continued until maturity. However, yield maintenance represents a true prepayment since the lender receives a lump sum at the time of prepayment and cancels the loan. Defeasance represents an effective prepayment for the borrower, but the investor does not cancel the loan and in fact continues to receive the same regular payments until loan maturity. The lien is shifted from the real property to the securities portfolio, but the loan remains in place and nearly all of the original borrowers’ rights and obligations are assumed by the successor borrower during the defeasance.
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How old is the defeasance concept?
The concept of a defeasance has existed for over 300 years. Early references come from the 18th century, when it was used to create a “defeat” option upfront for liens: “A defeazance is a collateral deed, made at the same time with a feoffment or other conveyance, containing certain conditions, upon the performance of which the estate then created may be defeated or totally undone.”
William Blackstone, Commentaries on the Laws of England 327 (1766)
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