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The current uncertainty in the credit markets is a useful reminder to borrowers to always anticipate market volatility when structuring their loans. In particular, real estate owners with securitized loans should take care to ensure that the defeasance process operates as an efficient and effective hedge on interest rate movement. In order to understand the hedge function of a defeasance, it is first necessary to understand what a securitized loan is and what restrictions are placed on a borrower relating to paying down the loan ahead of schedule. Securitization of a loan is a financing process in which loans secured by income-producing collateral are conveyed to a holding entity in which bonds, or other debt securities, are issued to investors. To make such securities attractive to investors, and to ensure that there is the continual income stream necessary to pay the interest on these securities, the loans contain provisions that prevent the borrower from paying off the balance of the loan prematurely. Generally, in order for a real estate borrower with a securitized loan to be discharged from its obligations in connection with a sale or refinancing, it must first replace the income stream generated from the real estate with some other form of income-producing collateral. A defeasance of a securitized loan is exactly this process: A borrower, without paying off its existing loan, exchanges the income-producing real estate collateral that is securing its financing with another type of income-producing collateral. Upon this swap of the collateral, the borrower is released from its obligations under the loan documents and can sell its real estate unencumbered by the loan, or grant a mortgage in the real estate in connection with a refinancing on more attractive loan terms, without incurring monetary penalties. Typically, regulations governing these debt security issuances require that the exchange collateral for the real estate be a portfolio of U.S. Treasury securities or other fixed-rate bonds offered by certain government agencies. The borrower purchases treasury securities or other bonds that distribute income over time as needed to make the scheduled payments on the loan. The borrower then grants a security interest in the securities portfolio to the lender. Simultaneous with this granting of the security interest in the securities portfolio to the lender, the borrower assigns all of its rights, title, and interest in the securities and the loan documents to a “successor borrower,” who steps into the shoes of the original borrower and becomes the obligor under the loan documents. Usually, for purposes of ease and finality, a successor borrower is a third-party company which agrees to take on the liabilities and obligations of the loan in exchange for a fee. Once this process is completed, the original borrower no longer has any obligations under the loan documents, and its real estate is unencumbered by a mortgage. HEDGING FUNCTION Because a defeasance involves purchasing securities to replace the real estate as collateral, defeasance does have a cost. The cost is a function of the interest rate of the existing loan and the rate on the securities that the borrower purchases to properly complete the defeasance. If the rate on the securities purchased is lower than the interest rate on the existing loan, the cost of the securities will exceed the principal balance of the loan. This “defeasance premium” should mathematically correspond to a traditional yield-maintenance formula used by lenders in the prepayment of a loan. The greater the gap in the interest rates, the greater the premium or cost to the borrower. Conversely, if the rate on the securities is higher than the rate on the existing loan, it is possible to defease the loan with securities that cost less than the principal balance of the note. In times where the cost of money is rising and cap rates are becoming less attractive, an owner wanting to realize on increased equity through a refinancing or sale should take some comfort that if the defeasance process contained in the original loan documents is properly structured, the defeasance will act as a hedge on such volatile interest rate movement. CAREFULLY CRAFTED DOCUMENTS In order for the borrower to fully maximize the benefits afforded by the defeasance, careful attention to the loan documents at origination is necessary. Remember that the loan documents will have prepayment lockout periods during which the borrower will not be allowed to pay off the loan. The provisions governing when such periods begin and end should be tailored to provide the appropriate incentives for the lender to begin the securitization process promptly. In addition, a standard securitized loan does allow a borrower the right to prepay its loan in the final three to six months (or more) of the term of the loan. If this “open-prepayment window” exists, then, at a minimum, the defeasance provisions should provide that the borrower has the right to defease through the first date on which it would otherwise be allowed to prepay the loan, rather than defease through the final maturity date of the loan, thereby eliminating the final months of interest payments. Securitized loans usually provide for monthly payments of interest only, with a lump-sum balloon payment at the end of the term in the amount of the outstanding principal balance. When the borrower purchases the securities it needs to replace the real estate collateral, it must purchase securities which will generate income sufficient to make both the interest payments and the final balloon payment. Inefficiencies in the securities market, however, may create situations where securities that mature in time to make the balloon payment at the beginning of the open-prepayment window are more costly than securities that will mature later in the open-prepayment window. Therefore, the loan documents should provide for a defeasance through any payment date in the open-prepayment window, rather than just the first such date. Borrowers should avoid provisions that require the delivery of a defeasance deposit rather than defeasance collateral to eliminate any role a lender may have in the selection, and thus pricing, of the securities. To provide the borrower with the greatest discretion in choosing which securities it delivers as defeasance collateral, the loan documents should be specific in describing the permitted securities to include not just treasury securities but agency bonds, as well. Because the treasury securities available for purchase on any given day are unlikely to produce income in such amounts and at such times that will exactly match the loan payment requirements, what often happens is that some of the treasury securities will mature in advance of the payment dates under the loan documents or mature in amounts greater than is necessary to pay the amount required under the loan. In such situations, the early or additional cash generated from the maturity of these securities is invested in a securities account until the payment is required under the loan. Thus, particularly in situations where the term of a loan is long, it is likely that these investments will earn a significant amount of interest. A smart borrower will agree with the successor borrower in advance about how that additional money or residual value in the securities account will be distributed between the borrower and the successor borrower after the loan is fully repaid. Therefore, provisions that do not allow the borrower to freely designate the successor borrower should be avoided, as the ability to choose among different successor borrowers gives the borrower leverage in negotiating the proper sharing arrangement. TAX IMPLICATIONS In jurisdictions that tax the recording of a mortgage, completing a standard defeasance (in other words, one in which the existing mortgage is released upon the pledge of the securities portfolio) to refinance with a new lender and new mortgage will result in the imposition of a tax. Because of the tax rates of most applicable jurisdictions, defeasing an existing loan in order to refinance with a different lender may often be cost-prohibitive. However, many borrowers and lenders are now attempting to replicate the standard practice in New York. Because of an advisory opinion issued by the Department of Taxation stating that no tax is owed upon the assignment of mortgages in connection with certain refinancings, the standard practice in New York is for the lender to assign the existing mortgage to the new refinancing lender (rather than release the mortgage), which allows the borrower to retain the benefit of having already paid the tax on the principal amount of the loan being defeased. This is accomplished by having the borrower enter a new note (the defeasance note) with the refinancing lender on the same payment terms and conditions as the existing note, as well as a security agreement pledging securities as collateral for the defeasance note. The note and pledge agreement are then assigned by the refinancing lender to the existing lender in consideration of the assignment of the existing note and mortgage to the refinancing lender. The refinancing lender may then amend and restate the existing note and mortgage, and the borrower will only pay taxes on any additional amount over the principal balance of the existing loan. IN THE DISTRICT In the District of Columbia, whether such an assignment of mortgage results in the imposition of a tax is less clear. A recordation tax is imposed by Title 42, Chapter 11 of the D.C. Code on the recordation of certain instruments in the land records. However, the confusing Section 42-1102.01 provides that the sale or assignment of a mortgage or deed of trust from one lender to another, on the “secondary market,” where there are no changes in the terms or conditions provided in the instrument and the borrower has taken no action to “refinance,” is exempt from the recordation tax. The terms “secondary market” and “refinance” are not defined, however. One could infer from the language of the statute that if the transaction did not meet the criteria of the section, a tax would be imposed. Nevertheless, the only affirmative imposition of a tax in the statute is triggered by the recordation of certain enumerated instruments. Thus, one could also infer that, absent such instruments being recorded, no tax would be imposed even if the transaction did meet the criteria of Section 42-1102.01. The fact that the description of the instruments that do trigger the tax is also fairly vague only adds to the confusion. The unfortunate language of the D.C. statute has resulted in some unusual practices with different borrowers, lenders, and servicers requiring that the defeasance transaction be structured in different ways. Due to the lack of a clear standard on the recording tax issue, the agencies that rate the debt securities — so that the third-party investors understand what they are purchasing — have made it a policy in most cases either to require the mortgage tax to be paid or to require that the mortgage assignment be recorded, as a precondition to maintaining the same debt securities rating on the loan with treasuries as collateral as was on the original loan with real estate as the collateral. Notwithstanding these requirements, with careful negotiation of the loan documents at the origination of the loan, it is possible to provide for a New York-style defeasance in the District that does not result in a recording tax being paid with this type of refinancing. The proper negotiation of loan documents at the origination of securitized loans and a solid understanding of the mortgage-recording tax of the applicable jurisdiction are both critical elements in achieving flexibility and cost savings during the defeasance of such loans, and they allow a borrower to maximize the hedging function inherent in the defeasance process during what may otherwise be difficult financial times.
Stephen M. Bellotti is a shareholder in the Washington, D.C., office of Greenberg Traurig, practicing commercial real estate development and financing.

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