How Borrowers Can Navigate Loan Defeasance Transactions

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on September 6, 2022.

Every borrower looking to refinance an existing commercial real estate loan or sell a property encumbered by one needs to consider how to release its existing financing. Commercial loan documents typically require either a prepayment premium or a loan defeasance if the borrower intends to exit the loan prior to maturity. While most traditional loans require the payment of a premium as a condition of an early exit, some require the borrower to “defease” the loan instead. Following is a simple blueprint for borrowers navigating the defeasance process.

We begin with the basics. Unlike a traditional commercial mortgage loan that may be prepaid, a loan with defeasance provisions requires the mortgage loan to stay in place until maturity but allows the real property collateral to be replaced with securities (typically treasury bonds). The defeasance transaction will be structured so that the treasury bonds (1) have values at maturity equal to the remaining term of the loan and (2) a rate sufficient to produce enough cash to cover the monthly debt service payments on the existing loan. With this structure in place, the existing borrower can have the lien on the property released. Simultaneously with the release of the lien on the real property, an entity unrelated to the existing borrower will take over as a successor borrower of the loan with the treasury bonds now serving as the collateral.

Lenders typically require a loan defeasance when loans are pooled with numerous other loans and sold as securities, commonly known as commercial mortgage-backed securities. For example, Freddie Mac loans for multifamily projects are routinely pooled and sold as securities. Because of the complexity of this financial instrument, the lender must keep each borrower’s loan in place through maturity, rather than allow a borrower to prepay and exit the loan.

The first step a borrower should take when considering a loan defeasance is to engage legal counsel to closely review the existing loan documents for provisions related to loan defeasance. The loan documents will describe the defeasance requirements and associated fees. A defeasance fee is usually due in advance of the closing and will likely be nonrefundable if the loan defeasance transaction ultimately does not close.

The borrower will also ordinarily have to pay any of the lender’s costs and expenses in connection with the defeasance transaction, including the lender’s attorney’s fees. Interestingly, one unexpected benefit to recent interest rate increases is that the total cost for a loan defeasance transaction for a borrower will probably be less than they were during the past few years of historically low interest rates. When interest rates rise, the treasury bonds used as replacement collateral for the mortgage loan become less expensive to purchase. Fully understanding all the potential transaction costs of a loan defeasance is a key concern because such costs may affect the decision regarding when to refinance or sell a property.

Loan documents also normally restrict when a loan defeasance transaction may occur. For instance, there is typically a lock-out period after a loan closing so that the lender can have adequate time to bundle and sell the loan. Further, the loan documents should contain very detailed notice requirements regarding when the loan defeasance transaction is expected to close. A typical notice provision would require the notice to be received 30 to 60 days prior to the closing date of the loan defeasance. Most loan documents also require that the borrower pay the defeasance fee when it sends the defeasance notice.

Around the same time a borrower has engaged legal counsel to review its existing loan documents, a borrower should hire a specialist in loan defeasance coordination. Loan defeasance specialists can provide detailed projections on the costs of a defeasance transaction and will coordinate the workflow of the various parties. Utilizing a coordinator is recommended for any borrower regardless of familiarity with the process because a loan defeasance is a highly specialized transaction.

A loan defeasance commonly takes about 30 days to close. To start, the loan servicer’s counsel will prepare a set of defeasance documents. The existing loan documents will dictate the substantive terms of these documents, including details about the securities the lender will accept, appointment of a successor borrower, and commencement of the process of defeasance. Many of the legal documents required for a loan defeasance are standard forms and lenders will be very hesitant to substantially alter them, but they should be reviewed carefully nonetheless. The typical set of documents will include a pledge and security agreement; an account agreement, an assignment, assumption, and release agreement; various certificates; detailed escrow instructions; and a legal opinion from the borrower’s counsel. A borrower will also likely need to obtain a title insurance commitment and prepare internal authorizations for the transaction.

The major events of a loan defeasance transaction will include: (1) the borrower sending the lender notice of defeasance and the defeasance fee; (2) the lender acknowledging receipt of the notice and notifying the existing borrower of the successor borrower; (3) the defeasance coordinator scheduling a kick-off call with all parties; (4) the borrower’s counsel and lender’s counsel finalizing the legal documents; (5) the loan defeasance coordinator identifying treasury bonds to purchase from a broker-dealer; (6) the funds being delivered for purchase of the treasury bonds during a two- to three-day closing process; and (7) the real property being released from the loan and replaced with the treasury bonds.

A loan defeasance for a commercial real estate loan is a complicated and specialized process. However, if a borrower engages experienced professionals familiar with such transactions, navigation of the transaction should be painless.