If you have a fixed-rate commercial real estate loan, it's likely subject to a high prepayment penalty. However, what most real estate investors don't know is that they may be able to use loan defeasance to sidestep paying those fees.
Keep reading to learn more about what this financing strategy is and how it works, as well as the pros and cons of choosing this method when you're ready to sell or refinance your investment property.
What is loan defeasance?
At its core, loan defeasance is a way for commercial mortgage borrowers to avoid paying a prepayment penalty if they decide to pay off their loan early. The defeasance process allows the borrower to replace the loan's original collateral (which is most likely the mortgaged property) with another asset.
The new collateral is usually made up of government securities, such as Treasury bonds. Notably, the bonds need to produce the same level of income as the original loan payment, allowing the mortgage lender to keep the same amount of cash flow on its balance sheet and the owner of the property to own the asset outright. The loan is then transferred to a successor borrower, who will receive periodic interest payments from the defeasance collateral.
Usually, this financing scenario occurs when the owner of the property wants to refinance or sell. However, only certain types of securitized loans allow for loan defeasance. At the very least, the loan needs to be a commercial real estate loan for defeasance to be an option. However, this type of prepayment arrangement is especially common with commercial mortgage-backed securities (CMBS loans).
What are the advantages and disadvantages of loan defeasance?
The major advantage of loan defeasance to the borrower should be fairly clear. A defeasance transaction allows the borrower the freedom to sell or refinance a property (for leverage or any other reason) before they have paid off the original loan. In addition, it allows them to take advantage of prepayment without having to pay a hefty prepayment penalty.
The advantages to the loan servicer are also pretty straightforward. Defeasance allows it to keep the same amount of cash flow on its balance sheet while getting rid of some of the risks in its investment. Government securities, like Treasury bonds, are notoriously low-risk, so the servicer also comes out ahead in this arrangement.
The disadvantage of loan defeasance for real estate investors is that it can be costly. Since Treasury bonds are directly impacted by interest rate fluctuations, buying bonds can become expensive for the original borrower if interest rates are high. Although, it's worth noting that, in some cases, agency bonds, like those offered by Fannie Mae and Freddie Mac, will be acceptable in lieu of true government securities -- and those options are often more affordable.
Truthfully, there is little risk to the loan servicer in this scenario. To start, loan defeasance reduces the potential for reinvestment risk. Additionally, allowing government securities to be the defeasance collateral increases the probability that investors will receive all their contracted payments.
What should investors know before deciding on loan defeasance?
If you're thinking of refinancing your mortgage loan or selling your investment property and would like to explore a defeasance option, the first thing to do is read your loan document carefully. In order for this to be an alternative to a prepayment penalty, the document must contain a defeasance clause. If it doesn't, you will have to explore other options for prepaying your CMBS loan.
Additionally, before deciding on defeasance for your commercial loan, it is usually wise to get in contact with a defeasance consultant. The defeasance process can often be complicated and can impact your return on investment, so it's a good idea to connect with an expert who can help you weigh your options and walk you through your rights and responsibilities.
The Millionacres bottom line
While defeasance may be a more affordable option for some commercial real estate investors who are facing the prospect of a high prepayment penalty, it's not right for everyone. If you're considering going this route for your commercial mortgage, don't hesitate to reach out to experts who can answer your questions about the process. In the meantime, let this guide help you get started thinking about whether loan defeasance is the right move for you.