Defeasance is Shark Repellent
Blood is in the water. Sharks are circling.
It’s no secret that real estate owners feel intense pressure due to the pandemic. While real estate costs remain largely fixed or are increasing, global shelter-in-place orders have drastically reduced the timely collection of rents. This inevitable cash flow hemorrhage leaves many property owners desperate for relief. Stimulus programs launched simultaneously by the Federal Reserve, Congress, and the President, resulting in ultra-low short and long-term interest rates, are welcome lifeboats for property owners.
Unfortunately, massive uncertainty surrounding the speed and completeness of the economic recovery is keeping many traditional lenders on the sidelines; banks, insurance companies and non-bank lenders just can’t get comfortable lending while the waters remain choppy. Although those institutions are in much better shape than they were going into the 2008 financial crisis, painful lessons from those years are still fresh in their minds. For lenders, while chaos is in plain view, maintaining liquidity outweighs return.
Everyone is bruised and bleeding. So, sharks are circling, waiting for prey to weaken enough to be an easy meal.
Among our clients, we observe owners of multi-family properties doing better than widely expected. Among many factors, massive stimulus programs have bolstered the ability of individual renters to meet their obligations, at least temporarily. Many of these owners have substantial equity to act as a buffer in difficult times. And they have longstanding, constructive relationships with lenders.
A Case Study
An example: a client recently closed on a refinance loan after successfully defeasing their prior loan with the help of Derivative Logic’s Defeasance Services team. Their new loan reduced the credit spread by 55 basis points off their existing interest rate, which resulted in reduced monthly interest costs and increased their ability to borrow more than the original loan amount. As an extra bonus, the defeasance released several millions of dollars in the interest reserve fund held in escrow by the Master Servicer. Reducing the credit spread in a refinance, in most cases, makes the case to defease all the easier.
A defeasance was needed to power these gains because the original borrowing was a conduit loan. Shortly after it was signed, their loan was incorporated into a CMBS (Commercial Mortgage Backed Securities) bond. The mortgage securing the loan now served as collateral for the CMBS. Consequently, their loan agreement forbade them from pre-paying their loan to free their property of its mortgage obligation for about 36 months. The solution to unencumber the property was by carefully constructing a portfolio of replacement collateral, namely Treasury and Agency securities. The multimillion-dollar securities portfolio, which our client purchased, precisely produced the cash needed to pay the remaining monthly principal and interest and cover the balloon payment due on the loan maturity date.
The substantial equity our client held in their property allowed them to finance the cost of the defeasance portfolio and associated fees via a new loan. In other words, they borrowed the funds necessary to close their defeasance at their new, lower rate.
The result was effective shark repellant. While there is an upfront cost, our client is now much less likely to be forced to sell his property involuntarily. The new loan’s lower monthly payments meaningfully offset the expected reduction in rents they face. The millions returned from escrow meant their immediate cash position dramatically improved. As a direct result of their defeasance transaction, and subsequent refinancing, they now have enough financial breathing room to keep their head comfortably above water and ride out the storm. Our client was delighted with these results. At the end of the day, the sharks swam away frustrated, looking for easier pickings.
An important take away: Do not focus on the pre-payment premium. There is going to be a cost to replace the collateral, but one needs to do deeper analysis to determine if the cost to defease is compensated in other ways. Let us help you with the analysis so you can make an educated decision based on the numbers and other variables. With term rates at historic lows, it makes sense to review all securitized loans. You might be pleasantly surprised that the cost to defease is not a big deal. What’s the big deal if the cost is $5mm and the savings is $7mm over time to refinance? And there might be other easily overlooked benefits to a refinance that a defeasance will unlock. Call us to help you identify your opportunities.
Clearer Sailing Ahead?
The strong seek to swallow the weak. That’s the only rule in blood-red real estate waters. The secret to surviving is the same as it’s always been. Use assets you control to avoid being forced to sell before the time you choose. Judging from our pipeline, if you have a multi-family property, now may be a good time to review refinance options to take full advantage of ultra-low interest rates. And a defeasance is likely the key to getting that done, especially if you’re currently in a CMBS or other securitized loan.
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Contact us at (415) 510-2100 to discuss your unique situation. We’re expert interest rate advisors and we help clients safely navigate their defeasance needs.