Many clients inquire about financing their real estate projects in the “conduit loan” market. There are a number of lenders in this marketplace providing an assortment of typically aggressive rates. While at first glance this category of loans may appear to be quite favorable, however, before deciding to proceed, it is advisable to review a short history of the procedure in connection with the eventual repayment of such loans. The following is a short summary of a portion of the history and procedure in connection with the “defeasance” process inherent in any conduit loan.
A Short Defeasance History.
Defeasance first became a part of the commercial mortgage-backed securities (“CMBS”) [1] world during the early 1990’s as a mechanism to make pricing on CMBS more favorable and has now become a nearly unremoveable fixture in the CMBS industry. Defeasance eliminates the prepayment risk associated with fixed-rate loans by providing an alternative mechanism under which the borrower can obtain a release of the lien of the mortgage securing the loan (to accommodate a sale or refinance of the real estate collateral) by delivering government securities as a substitute collateral for the loan. The purpose for this is based upon the premise that in the CMBS industry, certificate-holders carrying securities backed by securitized loans want predictable and uninterrupted cash flow. Prepayments, whether voluntary or involuntary, create a disruption to this cash flow. To address the interests of certificate-holders in receiving a predictable and continuing cash flow, virtually all CMBS loans typically prohibit a borrower’s prepayment of a loan prior to the expiration of a specified “lock-out” period. In the CMBS market, this lock out period typically extends until the last 60-90 days of the loan term. Defeasance is a means to balance the effect of the loan’s lock-out provisions against the borrower’s need to obtain a release of the REMIC trust’s lien on the related collateral (as may be the case in a refinancing or sale of such collateral).
What is Defeasance?
Defeasance is the substitution of one type of collateral for another. In the CMBS industry, defeasance is the process by which the real estate and related collateral securing a mortgage loan is replaced by government securities in order to release the original collateral while keeping the payment stream for the mortgage loan intact. In a defeasance, the original loan continues to be held by the REMIC trust. [2] The government securities that replace the real estate collateral are modeled so that the income stream from those securities replicates the remaining payments due under the terms of the loan. It is important to remember that the loan obligation is not cancelled when defeasance occurs, as would normally occur with a prepayment. Instead, the note and loan remain in full force and effect through the maturity date, with the payments under the loan being paid as the government securities redeem. In addition, defeasance is favorable to certificate holders carrying certificates backed by securitized loans because the opportunity for a borrower to default following a defeasance is significantly reduced (thereby avoiding the risk of early payment due to acceleration of the loan). [3]
Additional Cost Issues.
In addition to the foregoing, conduit loans commonly carry some additional requirements that can create additional expense to a borrower. In particular, CMBS defeasance transactions are governed by New York law, so a New York perfection opinion issued by a law firm (often the loan servicer’s counsel) is required by the loan servicer. The NY perfection opinion letter confirms that the REMIC trust has a perfected security interest (by possession and control under Article 8 of the UCC) in the government securities that serve as the pledged collateral.
Further, conduit loans often require creditworthiness ratings by rating agencies. Rating agencies are private companies that rate the creditworthiness of bonds. The three (3) best known rating agencies are Moody’s Investors Services, Standard and Poor’s and Fitch ICBA. Typically, at least two (2) of the three (3) major statistical rating agencies rate the bonds issued to investors by a REMIC trust. Because defeasances can create issues that could cause the REMIC trust to lose its tax status as a REMIC, the rating agencies review the defeasance documents for certain large loans that meet the criteria established by the rating agencies for rating agency review. The fee charged by a rating agency for their review of a defeased loan is typically paid by the borrower pursuant to language in the borrower’s loan documents.
In addition, CMBS defeasance transactions must be completed in compliance with REMIC regulations, so, following securitization, a REMIC opinion issued by a law firm (often the loan servicer’s counsel) is required by the loan servicer. The REMIC opinion letter confirms that the defeasance, as structured and documented, will not cause the REMIC trust to lose its status as a REMIC.
Conclusion.
Conduit loans typically offer more aggressive rates for real estate investor/borrowers, however, such aggressive rates come at a sometimes hidden price. In an effort to meet the demands of the CMBS marketplace, real estate investor/borrowers are subject to substantially less flexibility, additional costs and more procedural hurdles to accomplish repayment. Prior to proceeding with conduit loan financing, it is advisable to consider much of the foregoing.
[1] CMBS is an abbreviation for “Commercial Mortgage-Backed Securities.” Loans for which the lender’s exit strategy is securitization by transfer of a pool of loans to a Real Estate Mortgage Investment Conduit (“REMIC”) trust are often referred to interchangeably as “CMBS loans” and “conduit loans.” A conduit loan is the same as a CMBS loan. The word “conduit” in this context refers to the pass-through tax status of the REMIC trust to which the lender intends to transfer the loan in a securitization.
[2] When mortgage loans are securitized in the CMBS industry, they are put into REMICs which are governed by complex tax regulations. A REMIC generally retains its tax-free status only if the REMIC holds “qualified mortgages” and “permitted investments.” A REMIC trust is the entity to which a lender transfers its loans when it securitizes them. There are a number of complex regulations in the U.S. tax code that govern the creation and maintenance of a REMIC trust. REMIC Trusts issue bonds to institutional investors that are backed by commercial mortgages or other assets.
[3] Default risk is reduced because the lender holds government securities which the borrower has no right to sell or liquidate and which make the loan payments directly.