To Defease or Not to Defease? That is the Question
- Mar 18, 2015
Many commercial property borrowers are prepaying their CMBS loans in order to refinance at today’s historically low interest rates. The majority of CMBS loans have costly, complex “defeasance” provisions that allow prepayment only if the borrower replaces the mortgage collateral with a package of U.S. Treasury securities. Put another way, there is a substantial penalty for prepayment.
Approximately $18.9 billion of CMBS loans were defeased in 2014, an increase of 17 percent from 2013 (Trepp). A closer look at the numbers reveals that defeasance activity is heavily concentrated among large loans. The average balance of loans defeased in 2014 was $15.5 million and the 15 largest loans totaled $3.6 billion, nearly 20 percent of the total amount defeased.
Defeasance is a complicated, expensive process that involves careful coordination of attorneys, brokers, consultants, rating agencies and trustees. Borrowers often hire defeasance consulting firms to manage this process. Defeasance costs can be 10 percent to 13 percent of the outstanding loan amount for loans that mature in two years. Of course, the cost goes down the closer one gets to maturity — the costs for a loan maturing in one year would be half as much — and in most cases loans can be prepaid without defeasance in the last three to six months of the loan term.
While the penalties are large, the interest savings over the life of the loan can be substantial if mortgage rates increase significantly, and today’s low rates can be locked in for years to come. Additionally, in today’s robust lending market, the defeasance costs can often be rolled into the new mortgage.
The logic seems sound, but is the pain and expense of defeasance really worth it? Or are you better off waiting to maturity to refinance?
Defeasance is a calculated risk … and a big one. The argument in support of defeasance becomes less clear when factors other than potential interest savings (such as cash flow) are considered. The actual cash flow savings over the remainder of the original loan term is unlikely to cover the defeasance costs so, the borrower has to look forward to estimate the hypothetical cash savings based on higher interest rates at the maturity of the original loan. And, the actual cash flow savings over the life of the new loan may be modest at best if one refinances with an amortizing loan, even if interest rates increase more than 1.5 percent or 2 percent Another concern is that the available refinance proceeds may not be sufficient to cover the defeasance costs, so the borrower might need to come up with that money out-of-pocket, making the transaction more painful.
To be sure, there are many variables to consider before making this major, and potentially very costly decision. If rates increase a lot, it’s a check in the win column, if not, defeasance is a loser. Since the stakes are so high, it pays to get some unbiased financial advice before going down the defeasance path.