How to Benefit from Negative Defeasance Before Your Loan Matures

Explore the Benefits of Negative Defeasance with Derivative Logic’s Expertise

In the complex world of commercial real estate, understanding and managing loan agreements is crucial for maximizing your investment returns. One such financial concept that every savvy investor should be aware of is defeasance, especially when it can multiply your advantage through what is known as a “negative defeasance penalty.”

What is Defeasance?

Defeasance is the borrower’s contractual right included in loan agreements that do not allow a borrower to prepay their remaining loan obligations, such as CMBS loans. Defeasance is specifically designed to provide borrowers with an alternative way to free their property from the lien of the mortgage before the loan term ends.
Defeasance allows borrowers to replace their loan collateral with a portfolio of very low-risk securities. This mechanism enables you to substitute the original collateral—usually your real estate property itself—with a new portfolio of securities (typically Government or Agency bonds) meticulously constructed to generate exactly enough income to cover all the remaining scheduled loan payments. It is almost always a part of loan agreements that prohibit early prepayment of the loan’s outstanding balance for most of the loan’s duration. This prohibition is usually because the loan becomes part of a Commercial Mortgage-Backed Securities (CMBS) securitization, the economics of which depend on all the loan payments happening as scheduled.

For CMBS loans, this option is typically available during a specific window—from now until about 3 or 4 months before the loan’s maturity date—a window known as the “Open Period.” If you wait until the Open Period, the ability to defease the loan vanishes, and you simply pay the outstanding balance plus accrued interest, without any penalty. Acting before this period could allow you to capitalize on the negative defeasance penalty, turning a potential cost into a financial benefit.

What is a Negative Defeasance Penalty?

What makes defeasance unique among prepayment methods is the possibility of a negative penalty. This “penalty” is the difference between the cost of an appropriate portfolio of bonds and what it would cost to prepay the outstanding loan obligations if the borrower were allowed to do so. Historically, this difference has been a positive number because it usually costs more to buy the necessary portfolio of bonds than the outstanding principal balance of the loan. That’s why this difference has traditionally been called a penalty. Because the portfolio comprises very low-risk bonds, it made sense that buying them required a “premium.”

A negative penalty occurs when the cost of the securities used as substitute collateral falls below the outstanding principal balance of the loan. Currently, with short-term yields remaining elevated, many borrowers are finding themselves in the fortunate position where they can defease their loans below par. If your loan’s interest rate is less than the yields in the relevant portion of the Treasury forward curve, you are likely to be enjoying a negative defeasance penalty opportunity.

As you approach the Open Period, the penalty diminishes, reflecting a “burn down” in potential costs. Do you have one of the approximately 500 Agency fixed loans maturing over the next year that may experience this negative penalty? You face a classic “use it or lose it” situation, where waiting too long means missing out on potentially significant savings.

Defeasance Challenges

However, while defeasance grants you the right to remove encumbrances on your property so you may refinance or sell it unencumbered, it comes with specific obligations and complexities that typically require specialized expertise to navigate effectively. The process involves several intricate steps, including:

1. Choosing Suitable Securities:
The securities that replace your property as collateral must meet specific criteria, ensuring they are sufficient to cover all future loan payments.

2. Structuring the Transaction:
The transaction must be meticulously structured to comply with legal and financial requirements, ensuring that it is executed without jeopardizing the benefits of defeasance and the interests of the investors in the CMBS structure into which your loan was incorporated.

3. Managing Timing and Costs:
The timing of the defeasance can significantly impact its cost-effectiveness. Expert advice is crucial in predicting and managing these costs to maximize financial benefit.

4. Handling Legal, Accounting, and Tax Implications:
Defeasance involves exacting legal, accounting, and tax considerations that must be carefully managed. The services of third-party specialists are needed to fulfill your obligations.

Work with Derivative Logic, Your Defeasance Expert

Given these contractual obligations, selecting a qualified defeasance expert is necessary. Derivative Logic has longstanding relationships with all the leading professionals needed to close your defeasance successfully and on time. These professionals provide critical and mandatory services for the defeasance on your behalf, ensuring that you fulfill all contractual obligations effectively and benefit fully from your right to defease. And we take great care to explain the entire process to you, providing you with a stress and worry-free experience.

If you’re considering prepaying your CMBS loan or just want a detailed estimate of the associated costs and benefits, reaching out to Derivative Logic is a smart strategic move. Contact Derivative Logic at us@derivativelogic.com or call (415) 510-2100 to discuss your options with a top industry expert like Steve Morus.

Invest wisely by understanding all your options, and remember, in the world of commercial real estate, timing and expert advice can significantly enhance your investment outcomes.