Retail real estate investors have seen signs of recovery over the last 12 months. Asset values in core markets are on the rise, and some borrowers are able to secure financing.issuance is beginning to rebound and new CMBS securitizations in the first quarter have been dominated by retail assets.
In addition, many life insurance lenders are reporting a 20 to 25 percent increase in their allocations for commercial real estate in 2011. While underwriting standards remain conservative, the increased availability of funds has fueled buyer demand for retail. Some investors report cap rates in the bestare now approaching 2007 levels.
These trends are driving an increasing volume of defeasance transactions. Defeasance, the preferred form of call-protection for the majority of CMBS loans originated during the past decade, is a substitution of collateral in which borrowers exchange a portfolio of government securities for the release of the mortgage. The defeasance process allows a borrower to exit a loan early when triggered by a refinance or sale transaction.
The largest potential cost of defeasance is the price of the replacement collateral over the outstanding principal balance of the loan, often referred to as the ‘defeasance premium.’ The extent of the premium depends on the original loan’s interest rate and remaining term, as well as the yield on the corresponding securities in the current market.
In 2006 and 2007, loose underwriting standards and dramatic increases in property values made the cost to defease an easy hurdle to overcome. Today, investors are burdened by severe declines in property values from 2007 levels. Less equity in many properties, coupled with historically low yields on government securities, has left many wondering what types of transactions are closing.
Given the trend toward more conservative underwriting, it is reasonable to assume that all loans being defeased are secured by ‘vanilla’ properties with low loan-to-value (LTV) ratios and short terms to maturity, but that is not necessarily the case. Defeasance transactions have varied in size from refinancing of small un-anchored properties to REIT portfolio recapitalizations. The acquisition market also has more all-cash buyers who are ready to defease and close on an expedited basis.
Since January 2010, retail property defeasances have represented close to 30 percent of total commercial defeasance activity. Approximately 43 percent of those defeasances were driven by refinancing, while 57 percent were driven by dispositions.
The average retail property defeasance involved a $10 million loan with a 6.80 percent interest rate and approximately 2.3 years to maturity. Retail owners have paid defeasance premiums ranging from 1.4 percent to 31.0 percent. The average defeasance premium was 11.0 percent over the same time period.
The loans that featured aspects that varied from the average but were still able to defease provide reason for optimism. They featured remaining terms ranging from seven years to just a few months and had occupancy rates that were as much as 12 percent down from origination.
One customer refinanced an un-anchored Maryland shopping center and absorbed a 17 percent defeasance premium with nearly three years left on the original loan. This was not a cash-out opportunity, but the owner was able to obtain new CMBS financing and negotiated provisions that will reduce future defeasance costs. By reducing the interest rate from 7.65 percent to 5.20 percent and increasing amortization from 25 years to 30 years, the owner was able to save more than $80,000 in annual debt service.
As CMBS 2.0 continues to evolve, it is important for property owners to move quickly. Anyone with debt maturing in the next 12 to 18 months should commence a dialogue with a broker or lender about refinancing scenarios.
Jeff Lee is Director and Jon Davis is Vice President with Commercial Defeasance LLC