Defeasance Without The Premium?
Can You Defease a Loan but Have No Premium?
Punchline first – yes, but it’s pretty uncommon. Before we dig in, a quick refresher.
Defeasance is a process where the real estate securing a piece of debt is swapped out for a portfolio of securities, typically US Treasurys or Agencys. The securities are structured to generate sufficient cashflow to cover the remainder of the P&I payments, balloon payment, and also secure the debt as the underlying real estate previously did. The result of this process is a release from the lien like any other payoff.
How Does This Happen?
The underlying securities in a portfolio are arranged to produce sufficient cashflow for the loan payments by (i) making coupon payments, and (ii) maturing at their par value. The cash accumulates in the intermediary account and gets disbursed to the servicer on each payment date until the loan maturity or open window (if permitted).
Borrowers who have been through a defeasance are accustomed to there being a “premium” to defease. A defeasance premium is the difference between the cost of the security portfolio and the outstanding principal balance (OPB). There’s generally a premium when Treasurys securities with the same remaining term as the loan are yielding less than the Note rate.
- In other words, if the Note Rate is 4.50%, but Treasurys are yielding 3.25%, then more securities must be purchased to make up the 1.25% delta, which results in a premium.
However, if Treasury yields are above than the Note Rate on the loan, then a portfolio of bonds can be structured to generate the remaining loan payments at a cost which is less than the OPB.
- If the cost of the portfolio is less than the OPB, then the defeasance premium is negative. Some borrowers view this as being “in the money” like with a swap.
This isn’t a common occurrence because most 10 year CMBS loans originated since the GFC have 4.00%+ rates and Treasurys haven’t been solidly above 4.00% since 2007. But 2020 changed things. When the 10T was sub 1.00%, many borrowers locked in fixed debt at sub 3.50% rates. Just looking at Freddie fixed, there were around 1,200 loans originated in 2020 with a rate below 3.50%. More specifically:
- 600+ have a Note Rate of 2.00%-3.00%
- 600+ have a Note Rate of 3.00%-3.50%
Many of these loans are approaching two years since being securitized, so they’re soon to be out of lockout if they’re not already.
Defeasance without the premium? It’s not super common but may become so in the near term.
What About Yield Maintenance?
Borrowers with loans subject to yield maintenance or make whole will also experience smaller penalties than years past. However, most of these loans contain provisions which prevent the penalty from being any less than 1% of the loan balance.
To get an understanding of your defeasance or yield maintenance premium, check out our calculators below.
Have a question? Reach out to defeasanceteam@pensford.com or 704-887-9880.
