A look at defeasance: Is now the time?

Highlights:

• Due to rising interest rates, commercial real estate investors may benefit now if they have existing loans with a defeasance prepayment option.
• Defeasing a loan may help investors reorganize investments and put money back into their pockets.
• With appropriate planning, you can avoid incurring surprise hits to your property’s cashflow.

Interest rates on mortgages and commercial real estate loans continue to rise across the country.

Commercial loans continue to increase as the first quarter of 2023 flies by. The average 10-year bank loan for multifamily commercial properties sat at 6.25% as of March 20, 2023, while Commercial Mortgage-Backed Securities (CMBS) loans have dropped by .40 and are between 5.62% for a 10-year loan and 5.97% for a 5-year loan.

Don’t discount defeasance as an option

Although at first glance rising interest rates on commercial property loans may seem concerning, the picture need not be gloomy–especially if your loan has a defeasance prepayment option. Why? As fixed rates increase, your cost to defease a loan decreases.

Defeasance requires the purchase of individual securities to replace each of the debt service payments remaining on your loan. Depending on the current interest rate environment compared to the interest rate environment when the loan was made, the cost to purchase those securities could be more or less than the existing balance of the loan.

For example, if you closed a loan with defeasance before last year, you may be looking at a scenario in which the securities necessary to defease your loan would cost less than the current loan balance. At the same time, if your property has experienced an increase in net cash flow, you may qualify for a larger loan.

Is it time to defease your loan?

If you could pay off your existing loan at a discount and replace it with a new loan at higher proceeds, would you do it? The likely answer is ‘yes.’

This scenario is not farfetched. Here are three real cases we’ve recently seen in which defeasance was the best option available to not only avoid negative hits to cashflow, but actually get a considerable amount of cash out.

Case 1

• Original Loan Amount: $28.2M
• Original Loan Date: December 2020
• Terms: 5 years, with a Note Rate of 2.51 percent

If the borrower now elects to refinance the loan, in today’s yield curve environment, the securities needed to defease the loan trade at a 3.2 percent discount—netting the borrower $895,341 in savings.

The property now supports a new loan of $40.2M, which equates to a 44 percent cash out.

Case 2

• Original Loan Amount: $27.6M
• Original Loan date: December 2014
• Terms: 10 years, with a Note Rate of 4.01 percent

If the borrower now elects to refinance, in today’s yield curve environment, the securities needed to defease the loan trade at a .1 percent discount—netting the borrowing $18,516 in savings.

The property now supports a new loan of $30.7M, which equates to a 19 percent cash out.

Case 3

• Original Loan Amount: $95.0M
• Original Loan Date: November 2020
• Terms: 10 years, with a Note Rate of 2.53 percent

If the borrower elects to refinance, in today’s yield curve environment, the securities needed to defease the loan trade at a 6.5 percent discount—netting the borrower $6.1M in savings.

The property now supports a new loan of $135M, which equates to a 46 percent cash out.

Crunch the numbers with Walker & Dunlop

As the above cases clearly show, defeasing a loan is sometimes the right move to make in an uncertain market.

Walker & Dunlop is a commercial real estate finance company with deep industry expertise in funding, selling, and investing in commercial properties. We work within all asset classes and use our proprietary insights to create tailored solutions for clients.

We focus on what matters most to our clients, creating a boutique experience that offers personalized services to understand your vision and help you achieve it. If you are interested in exploring your options for defeasing a loan, talk with a Walker & Dunlop expert today to discuss your portfolio goals and learn which solutions may be right for you.