Chatham Defeasance Calculator: Understanding the Process

What is Defeasance?

Defeasance is a complex financial transaction primarily used in commercial real estate to release a borrower from a loan obligation, typically a commercial mortgage-backed securities (CMBS) loan, before its maturity date without incurring a prepayment penalty. Instead of outright paying off the loan, the borrower substitutes the original collateral (the property) with a portfolio of government securities, usually U.S. Treasuries, that are structured to generate cash flows precisely matching the remaining principal and interest payments of the original loan.

This process effectively "defeats" the lien on the property, allowing the borrower to sell, refinance, or otherwise modify the property's financing without triggering the strict prepayment clauses often found in CMBS loans. The loan itself remains outstanding on the servicer's books, but the new collateral (the Treasuries) guarantees its future payments.

Why Defease a Loan?

Borrowers typically pursue defeasance for several key reasons:

• Property Sale: If a borrower wants to sell a property that is encumbered by a CMBS loan, defeasance is often the only viable option to clear the title and allow the sale to proceed, especially if the loan has a lockout period or a prohibitive prepayment penalty.
• Refinancing: To take advantage of lower interest rates or better loan terms, a borrower might want to refinance their property. If the existing loan is CMBS and still within its lockout period, defeasance can enable this.
• Equity Recapture: In a strong market, property values may have appreciated significantly. Defeasance allows owners to sell or refinance, unlocking equity that would otherwise be tied up until loan maturity.
• Portfolio Restructuring: For large institutional investors, defeasance offers flexibility in managing their real estate portfolios, allowing them to dispose of assets as needed.

The Role of Chatham Financial in Defeasance

When navigating the intricate world of defeasance, specialized advisory firms play a crucial role. Chatham Financial is one such leading independent financial advisory and technology firm renowned for its expertise in debt and derivatives, including defeasance. They provide comprehensive services that guide borrowers through every step of the defeasance process, which includes:

• Cost Analysis & Modeling: Providing precise defeasance cost estimates tailored to specific loan terms and current market conditions.
• Security Selection: Identifying and structuring the optimal portfolio of U.S. Treasury securities to match the loan's payment stream.
• Transaction Coordination: Managing the complex interplay between the borrower, loan servicer, rating agencies, trustees, and legal counsel.
• Legal Documentation: Assisting with the necessary legal agreements to execute the defeasance.
• Market Insight: Leveraging deep market knowledge to secure the most favorable pricing for the replacement securities.

Chatham Financial's involvement helps ensure that the defeasance is executed efficiently, cost-effectively, and in full compliance with all loan agreement requirements.

Key Components of Defeasance Cost

The total cost of defeasance is not just the price of the replacement securities. It comprises several factors:

1. Cost of Replacement Securities: This is typically the largest component. It's the present value of the remaining loan payments, discounted at the current yield of suitable government securities (usually U.S. Treasuries). If current Treasury yields are lower than the loan's interest rate, this cost will be higher than the remaining loan balance, resulting in a "defeasance premium." Conversely, if Treasury yields are higher, there could be a "defeasance discount."
2. Transaction Costs: These are the various fees associated with the process:
   • Defeasance Consultant Fees: For advisors like Chatham Financial who manage the process.
   • Legal Fees: For borrower's counsel, servicer's counsel, and trustee's counsel.
   • Servicer Fees: For their administrative work in processing the defeasance.
   • Rating Agency Fees: To ensure the defeasance does not negatively impact the credit rating of the CMBS bonds.
   • Successor Borrower Fees: If a new entity needs to be created to hold the defeasance collateral.
   • Miscellaneous Fees: Wire fees, custodian fees, etc.

Limitations and Considerations

While invaluable, defeasance is not without its complexities and limitations:

• Market Volatility: The cost of replacement securities can fluctuate daily with interest rates, making timing critical.
• Complexity: The process is highly technical and requires specialized expertise.
• Cost: While it avoids prepayment penalties, defeasance itself can be expensive, especially if interest rates have fallen since the original loan origination.
• Lockout Periods: Most CMBS loans have a lockout period (e.g., 2 years) during which defeasance is not permitted.

Conclusion

Defeasance is a critical tool for commercial real estate owners seeking flexibility with their CMBS-backed properties. By understanding its mechanics and engaging expert advisors like Chatham Financial, borrowers can successfully navigate this intricate process to achieve their financial and strategic objectives. Use our simplified Chatham defeasance calculator above to get a preliminary estimate, but always remember to consult with professionals for precise figures and guidance.