Understanding Defeasance in Commercial Mortgage

When you are planning to purchase a commercial property, you may discover that you have a variety of loan options. The traditional commercial mortgage is not always a good fit for your goals or plans for the property. Furthermore, you may find that in a traditional loan, you are not able to repay the debt in a timely manner. That may lead to some concerns about your long-term goals. By considering a defeasance with the help of a professional consultant on your commercial mortgage, it is possible to reduce the costs and to enjoy the benefits of a different payment strategy.

What is Defeasance in a Commercial Mortgage?

Commercial mortgage defeasance seems complex when you first evaluate your loan options. As the name implies, it is a strategy that allows you to reduce or avoid certain fees on your commercial mortgage. It prevents the fees associated with prepayment on your loan and benefits the lender by ensuring that the interest and principle are still paid on the loan.

A simple way to think about defeasance commercial real estate options for your loan is an adjustment to the traditional contract. The traditional commercial mortgage allows a lender to obtain a commercial mortgage-backed security, or CMBS, that offers a guaranteed return on their investment. It provides a level of security for the lender, which plays a critical role in the lender’s decision to offer mortgages for commercial properties.

The downside of a traditional commercial mortgage that uses CMBS for security is the limitations on prepayments. A borrower is not able to prepay on the loan without paying hefty fees and additional costs. That means the borrower may face challenges when selling or refinancing the property.

Commercial loan defeasance differs from the traditional contract because it allows the borrower to prepay on the loan and repay the full amount to the lender through alternative securities. You provide collateral in the form of government-backed security, such as treasury bonds. The security you offer to set up a contract with a defeasance on the loan depends on the mortgage interest rate. Ideally, a defeasance contract will provide collateral that gives the same rate of return as the original loan agreement.

Benefits of Defeasance for the Lender

Defeasance is a strategy that benefits the lender and the borrower at equal rates. The lender may agree to adjust the original mortgage on commercial properties when it offers a benefit that keeps up with their investment goals.

Since commercial real estate is often backed by a CMBS that investors use to ensure that they obtain interest on the loan, the primary concern about prepayment on a commercial mortgage is the loss of stable income. The original loan has a fixed interest rate. Investors expect that fixed rate of return on their investments, so they are not happy with the idea of prepayment on the loan. While a prepayment may have fees associated with the decision, it also throws off the lender’s long-term plans.

Defeasance replaces the interest with government-backed treasury bonds. As a result, the lender is able to continue making the same rate of return on the loan. That allows the lender to maintain their long-term goals for the duration of the mortgage. Furthermore, it offers a greater level of security for the lender. Since government bonds offer guaranteed income at a set rate, the lender does not need to worry about fluctuations in the real estate market.

Benefits of Defeasance for the Borrower

Although commercial loan defeasance benefits the lender, it also has positive benefits for the borrower. As a borrower, you are able to avoid prepayment penalties on your commercial mortgage. Since you replace the original contract with a new option that uses treasury bonds, the lender does not charge prepayment fees on your loan.

The secondary benefit of defeasance for the borrower is the greater level of flexibility. By repaying the loan through treasury bonds, you are able to sell the property without the lien. The new buyer is getting the property without a lien, so you are able to make a greater profit on your commercial property.

You also gain greater flexibility if you plan to refinance your loan. Defeasance allows you to take out equity loans or refinance a loan on the property without the complications of the original loan amount. You may get a lower interest rate on a new loan or you may be able to take out an equity loan on the property to make positive changes to the building. For example, it allows you to take out a loan on the equity to pay for repairs, renovations, or other projects that may arise.

Although Defeasance is regarded as the most punitive prepayment option, it may present a less expensive method than yield maintenance if rates are close or higher than the debt coupon.

Setting Up a Defeasance Contract

Commercial mortgage defeasance is a challenging process, and you may decide to work with a professional to start the process. Professionals may range from lawyers and accountants to specialized defeasance consultants. The goal is to set up a defeasance contract that benefits the borrower and the lender.

The primary reason to consider working with a professional is the variation in loan agreements. Each lender sets different terms, conditions, and standards when it comes to defeasance. You can usually find the details in your original mortgage documents and agreement. The contract will detail your options as it relates to the securities a lender will accept, appointing a successor, and even starting the process of defeasance. You may need to work with experienced professionals to navigate the process and ensure that you follow through with any legal standards that may apply to your situation.

Lenders may allow you to use agency bonds or other types of bonds rather than treasury bonds in some situations. You should also be aware that your original contract may have strict standards that apply to the process of defeasance. Make sure you understand the details of your contract to follow through with the new contract and always consult a professional.