Author: Dan Kahler
The defeasance provisions in CMBS loans are negotiable and will have a material impact on a borrower’s cost to defease. The following summary outlines important provisions, the potential cost impact, and our generally suggested language. Cost implications are measured in isolation, with assumptions listed at the end of the summary.
Preserve Successor Borrower Rights
Borrower should retain the right to designate the Successor Borrower. The Successor Borrower is an SPE vehicle that assumes ownership of the defeasance collateral, and holds legal claim to any residual value that accrues from this collateral (capable of reaching six figures). Originating lenders may attempt to capture this right and sell it to a third party, which third party will assess a fee to the borrower and retain all residual value.
Control of the Successor Borrower can also have accounting implications, as borrowers with control have an easier path to cancelling the debt from an accounting perspective via a “legal defeasance” (versus an “in substance” defeasance where a borrower may need to continue to recognize the debt after defeasance).
Potential Cost Impact1: 15 – 90 basis points on balance at defeasance (2 – 9 basis points in loan spread)
Suggested language2: In connection with a defeasance of the loan, Borrower shall establish or designate a successor entity (the “Successor Borrower”), which Successor Borrower shall be a special purpose entity acceptable to the rating agencies. Such entity may be an affiliate of Borrower, if Borrower so elects.
Preserve Collateral Purchase Rights
Originators may attempt to sell the right to execute the defeasance collateral purchase to a third party. The purchase is ultimately done using borrower funds. This right is often sold alongside the right to designate the Successor Borrower, described above.
This is problematic for three reasons:
Third party assesses a fee to the borrower for a “service” which adds no value (and can destroy value as described below)
Borrower loses control over the collateral purchase process and becomes a price-taker, resulting in a more costly closing
Third party does not answer to the borrower and has no incentive to create an efficient collateral structure on the borrower’s behalf (and may be incentivized to purchase a less efficient, more expensive structure if they own the Successor Borrower)
To preserve the collateral purchase rights, borrowers and advisors should avoid any language that involves lender as “agent and attorney-in-fact” for borrower, or language which causes borrower to deliver a sum of money for the collateral, rather than the collateral itself (e.g. “borrower shall deliver an amount sufficient to purchase”).
Potential Cost Impact1: $3,500 – $12,000 fee at defeasance (cost of an inefficient portfolio not quantified)
Suggested language2: In connection with a defeasance of the loan, Borrower shall purchase and deliver Defeasance Collateral which shall provide payments… [Avoid language that contemplates borrower delivering a sum of money for the purchase of the defeasance collateral, or lender as agent or attorney-in-fact for borrower]
Permit the Use of Agency Securities
Borrowers should be permitted to use agency securities in addition to Treasuries as defeasance collateral. These securities typically carry higher yields than Treasuries, and can reduce the overall cost of the collateral portfolio.
Potential Cost Impact1: 0 – 45 basis points on balance at defeasance (0 – 4 basis points in loan spread)
Suggested language2: Defeasance Collateral shall mean securities evidencing an obligation to timely pay principal and/or interest in a full and timely manner that are “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act of 1940, as amended, which in each case are not subject to prepayment, call or early redemption.
Permit Flexibility in Structuring the Collateral
Borrower should have the option to structure payments from the collateral to conclude on the open prepayment date, the maturity date, or any payment date between the two.
In a low-rate environment (securities yields lower than the interest rate on the loan), structuring collateral to the earliest date will generally produce the lowest cost, as each additional interest payment adds to the premium (e.g. discounting a 4% interest payment at a 2% security yield).
In a high-rate environment, including these additional payments could be beneficial, as borrowers could extend the positive yield differential and reduce collateral costs.
Potential Cost Impact1: 15-90 basis points on balance at defeasance (2 – 9 basis points in loan spread)
Suggested language2: Borrower shall purchase Defeasance Collateral which provides payments on or prior to, but as close as possible to, all successive payment dates after the date of defeasance through the monthly payment date selected by Borrower that is either the open prepayment date, a monthly payment date following the open prepayment date, or the maturity date (as selected by Borrower).
There are additional cost-saving provisions borrowers can incorporate to further reduce the costs. Chatham Financial will conduct a no-cost review of term sheets or loan documents to identify these provisions.
Regardless of loan language, there are measures borrowers should take at the time of defeasance to preserve value and minimize risk.
Monitor Consulting Fees
Defeasance consultants should be chosen on the basis of their service offering, reputation, and total fees. Fees are fungible, with some consultants charging a low consulting fee, but adding on expediting fees, Successor Borrower fees, Successor Borrower legal fees, and collateral purchase fees. Advisors and borrowers should be aware that these fees are generally under the consultant’s control, and should be viewed in aggregate as the consultant’s total fee3. Additionally, borrowers should receive cost savings if defeasing multiple loans or notes through a single transaction (i.e. borrowers should not pay 3x fees for a three-loan defeasance).
Require Collateral Purchase via Auction
The method used to purchase the collateral will have an impact on the cost. Consultants can attempt to negotiate directly with a single bank, but securities inventory varies from bank to bank meaning there is no guarantee that the consultant is achieving the lowest possible cost (even if the bank were to take zero profit). The only way to ensure the lowest possible cost for the borrower is to hold a live auction among the most competitive banks, which will expand the universe of securities and force banks to compete on margin.
Be Wary of Securities Price Indications
It should be noted that market pricing indications for the defeasance collateral should not be a consideration when choosing a defeasance consultant. The price of the securities will change and indications can be manipulated.
Transfer Shortfall Liability
The loan will remain outstanding after defeasance, so the risk of default is not eliminated. The defeasance consultant as Successor Borrower should assume this risk in isolation, as it is their responsibility to select and structure the replacement collateral. The original borrower should not remain liable.
Chatham Financial has executed over $65 billion principal defeased, and returned over $140 million in residual value to borrowers. Defeasance consultants are a part of Chatham's global real estate financial risk management practice, solving common but complex capital markets challenges for commercial and multifamily real estate investors.
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1Assumptions: 10-year I/O loan at 4.25% │ defeasance 3 years prior to maturity │ 10% equity discount rate │ treasury rates as of 5-Feb-2017 │ open windows of 1 month vs. 6 months to provide range │ agencies spread of 0 bps to 15 bps to provide range │ residual value from prepayment (if not structured to open window) │ 90% Successor Borrower value captured by borrower
2Specific language should accommodate any relevant defined terms. Contact ChathamDefeasance@chathamfinancial.com for a complimentary review of term sheets and loan documents.
3These rights will occasionally be sold, and as such may be divorced from the consultant’s service offering.