Defeasance
The process of releasing a borrower from its debt obligation (mortgage loan) and substituting the lien on the property with acceptable replacement collateral (typically treasury bonds). This replacement collateral is expected to generate a comparable substitute cash flow, which would otherwise be required on the existing debt were it not prepaid.
Putting “Defeasance” in Context
Scenario:
Harp Capital Partners, a real estate investment firm specializing in core acquisition investments, owns a high-profile CBD office building in downtown Seattle, known as Union Square Tower. The property is a Class A, 500,000 square foot office tower located in the heart of Seattle’s Central Business District. The building is fully leased to multiple high-credit tenants, generating stable and predictable cash flows.
Context:
In 2012, Harp Capital acquired Union Square Tower for $150 million, using a $100 million, 10-year fixed-rate CMBS (Commercial Mortgage-Backed Securities) loan at an interest rate of 5.50%. At the time, the Seattle office market was still recovering from the Great Recession, and the 5.50% rate was considered competitive.
Fast forward to 2018, Seattle’s office market has strengthened, and interest rates have dropped significantly. Harp Capital has received an unsolicited offer from a pension fund to acquire Union Square Tower for $200 million, far exceeding the firm’s original projections.
However, Harp Capital’s 2012 CMBS loan has a “no prepayment” clause, which means they cannot simply pay off the loan early without facing a significant penalty. To avoid this penalty and release the lien on the property, they will need to go through the defeasance process.
Defeasance Process:
Defeasance is the process Harp Capital will use to substitute the loan’s collateral (the property itself) with a portfolio of U.S. Treasury securities. These securities are designed to generate cash flows that match the payment schedule of the remaining loan. This ensures the lender receives the same stream of payments they would have gotten if the loan were not prepaid.
Here’s how the defeasance will work:
- Loan Balance: By 2018, Harp Capital has paid down the loan to $92 million, after making regular payments over six years.
- Treasury Securities: Harp Capital will purchase U.S. Treasury securities with maturities matching the loan’s remaining four-year payment schedule. These securities will produce the same amount of interest and principal payments the lender would have received through the loan’s full term.
- Cost: Due to favorable market conditions and lower interest rates in 2018, the cost of purchasing the required Treasury securities is approximately $94 million, slightly higher than the remaining loan balance but reasonable given the property’s significant appreciation.
Outcome:
Once Harp Capital purchases the Treasury securities, the lender releases the lien on Union Square Tower, allowing Harp Capital to sell the building to the pension fund for $200 million. Although the defeasance process required Harp Capital to spend an additional $2 million to purchase the Treasury bonds, this cost is offset by the large capital gain generated from the sale. After completing the sale, Harp Capital realizes a substantial profit, despite the expense of defeasance.
Why Defeasance?
Defeasance provides Harp Capital with the flexibility to sell Union Square Tower while keeping the terms of the original CMBS loan intact. Given that interest rates in 2018 are lower than when the property was purchased in 2012, defeasance makes sense for Harp Capital. Even with the cost of buying replacement collateral, the opportunity to capitalize on the property’s appreciation far outweighs the expense, allowing Harp Capital to achieve an attractive return on their investment.
Click here to get this CRE Glossary in an eBook (PDF) format.