Borrowers may need help navigating this complicated exit strategy.

by Regan Campbell

With commercial real estate credit markets slowly beginning to thaw, borrowers are beginning to explore the costs and requirements associated with exiting existing real estate debt. If the loan has been sold into a commercial mortgage-backed securitization, borrowers will likely find that their only alternative is to go through the loan defeasance process.

At its most basic level, a defeasance is a substitution of collateral and assignment of debt. The borrower is required to purchase a portfolio of government securities that will produce cash flows matching the debt service schedule of the original loan. This portfolio replaces the real property as collateral for the loan, enabling the borrower to obtain a release of the lien on the real estate property to facilitate a sale or refinance. Simultaneously, a new, or successor, borrower assumes the portfolio of securities as well as the payment obligations of the original loan. While the process sounds relatively straightforward, in actuality it is a complicated procedure involving numerous parties and considerable documentation.

Why Hire a Defeasance Consultant?

Although many borrowers are familiar with the basic process, most still opt to engage a consultant to assist in navigating the financial and legal aspects of the transaction. In addition to bringing clarity and order to an otherwise cumbersome process, a good defeasance consultant will play a key role in reducing the final cost by structuring and coordinating the purchase of an efficient defeasance portfolio and establishing the successor borrower entity in a way that returns a portion of the accumulated interest or residual value back to the original borrower.

Because defeasance is both an economic and legal process, it can take anywhere from three to six weeks to complete. The transaction brings a multitude of people to the table: the original borrower and its counsel, the loan servicer and its counsel, an independent accountant, the securities intermediary, a title and/or escrow agent, the successor borrower and its counsel, rating agencies, and the special servicer. Rather than the borrower and its counsel trying to manage the players and the process, the consultant should serve as a single point of contact for all coordination, including facilitating all conference calls, ensuring that documents and comments are circulated in a timely manner, and making sure that all requirements meet the borrowers closing timeline.

In addition to overseeing the entire process, the consultant also should be able to structure the portfolio of securities — typically U.S. Treasuries or agency securities, such as those issued by Fannie Mae or Freddie Mac. This replacement collateral must produce cash flows that match the debt service payments of the original loan, while still adhering to legal and industry standards, as well as making sure the types of securities that can be used to structure the portfolio adhere to the loan document requirements. This task is further complicated by gaps in the issuance of securities as well as the goal of price efficiency. Each servicer interprets the rules and requirements differently and its important that the consultant is familiar with the nuances of each servicers interpretation.

Once the portfolio has been structured, the defeasance consultant should coordinate the purchase of the securities on behalf of the borrower, ideally by holding a competitive auction. By including several market-maker banks, with each providing simultaneous real-time pricing, the borrower has the best chance of receiving the most efficient pricing possible.

The following example illustrates the importance of the auction process. A borrower needed to defease a CMBS loan with an outstanding balance of $14.7 million and five years remaining until maturity. The securities auction included four banks and resulted in a spread in price levels of more than $110,000 on the cost of the securities.