Ashley Menser, partner in the Federal & International Tax Group, explains the staying power of defeasances in a changing landscape.
Defeasance transactions have been around for a long time – why are we talking about them now?
While the transaction itself hasn’t changed much over the years, the CMBS industry has. Certain aspects of the transaction are now more relevant than ever to loan originators, and more educated borrowers are negotiating previously ignored details of the defeasance provisions.
The term defeasance is often used in the lending context – is it just a way to pay off a loan?
Defeasances are more useful than that: A defeasance is a transaction where a lender on any type of loan is able to release the lien on collateral pledged to it, while still protecting the yield for the lender and not simply allowing a payoff of the loan. The loan essentially remains in place, with substitute collateral that is a mixed portfolio of government securities, while the borrower is released from its loan obligations and can then sell or refinance the previously pledged property without the lien in place. The lender protects its investment in making the loan, and the borrower has flexibility to do what it needs to do with its property when it no longer needs the loan.
What types of loans allow for defeasance? Who should care about defeasances?
While most commonly seen in CMBS loans, defeasance provisions can be used for any type of loan with any type of collateral. It is a great form of call protection for lenders – whether the lender needs to protect its yield on a loan because it has pledged the loan as some form of collateral, or promised a particular income stream to investors. Defeasance can be modified to fit just about any type of lender and any type of loan.
Why should loan originators care about a defeasance provision if they plan to sell the loan eventually? And even if a lender doesn’t plan to sell the loan, aren’t all defeasance provisions the same?
The way the defeasance provision is drafted at origination carries implications for the loan participants years into the future. Who has the ability to select the replacement collateral when the loan defeases? What type of replacement collateral can be used? Who has the ability to choose the transaction participants, such as the securities custodian, securities broker and the replacement borrower? These decisions are made at origination but carry with them financial implications for all of the parties – including the original lender – many years after the loan closes.
CMBS has been off to a rocky start in Q1 2016, but defeasance remains steady. Do you see this trend continuing throughout the year?
Defeasance volume is tied to many factors, one of which is CMBS issuance. A healthy CMBS market certainly supports defeasance volume. Now, however, we are more frequently seeing other types of lenders behind the refinancing and acquisition financing that are driving a borrower’s need to defease. We are also seeing borrowers trying to reduce their overall debt by using cash to restructure. We see the market still requiring defeasance, even if CMBS issuance is not behind all of the new financing. Still, there are other market forces at play that impact where volume is headed in the future.