US defeasance and yield maintenance in commercial real estate loans--a view from the European market

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1 Page 1 This article was first published n Lexis PSL Banking & Finance n 30 April Click here fr a free trial f Lexis PSL. US defeasance and yield maintenance in cmmercial real estate lans--a view frm the Eurpean market 30/04/2014 Banking & Finance analysis: As the Eurpean real estate market cntinues t see an influx f US investrs ffering much needed liquidity, Andrew V Petersen, partner at K&L Gates LLP, and Juliette C Challenger, assciate at K&L Gates LLP, cnsider the key elements f the US cncepts f defeasance and yield maintenance and the emergence f these cncepts in the Eurpean cmmercial mrtgage market. Why are the cncepts f defeasance and yield maintenance f interest t the Eurpean cmmercial real estate finance market? The last tw years have seen an increasing number f US investrs enter int the Eurpean cmmercial mrtgage market. A buyant cmmercial mrtgage market, and a diversificatin f lenders ffering funding, has increased availability f liquidity, which has led t US capital flwing int the UK and Eurpean senir and mezzanine debt markets. The turmil in Eurpean banks as a result f the recent Eurzne crisis, the lack f liquidity in the Eurpean market, and the infancy f lending by alternative lenders in the UK and Eurpe, such as debt funds and insurers, as cmpared with their US cunterparts, has seen brrwers keen t take advantage f this capital influx frm the US. Prepayment fees have always been an essential element f US lans as a way f preserving the yield n the lan and, in relatin t securitised lans, prviding a predictable cash flw stream frm the underlying lan. In the US, prepayment fees are included in ne f three ways: declining balance frmula (ie a fixed percentage f the lan balance is paid n the utstanding lan balance, such percentage reducing as during the life f the facility) yield maintenance frmula, and defeasance The intent f bth defeasance and yield maintenance prvisins in lan dcumentatin is t prtect against prepayment and t allw lenders t realise the same yield as if the brrwer had held the lan t maturity. Defeasance and yield maintenance achieve the same bjective, in that the underlying real estate asset is unencumbered, but they are fundamentally different frm a legal perspective. The Eurpean cmmercial real estate market has, in cntrast t its US cunterpart, evlved withut the practice f defeasance r yield maintenance. Hwever, with a number f US entrants int the Eurpean cmmercial real estate market, there has been the intrductin f such requirements in cmmercial real estate lans. What is defeasance? Defeasance prvides an alternative prepayment mechanism and cmprises three elements:

2 Page 2 the substitutin f acceptable replacement cllateral, usually US gvernment securities, gilts r ther svereign bnds, specifically selected t generate sufficient cash t make all mnthly payments due thrughut the life f the lan and at maturity, fr the prperty cllateral underlying cmmercial real estate lans--ideally, the prtfli f securities chsen will be structured s that each f the securities matures n r befre a scheduled payment date under the lan, and the prceeds frm the maturity f each f the securities are used t make the mnthly payments due under the lan the assumptin f the lan by a special purpse vehicle, therefre keeping the debt bligatin alive as the lan remains utstanding fr its full term, and the discharge f the mrtgage frm the prperty enabling the brrwer t sell r refinance the prperty as it wishes Hw des the defeasance prcess wrk? The defeasance prcess is managed by a specialist defeasance cnsultant wh will select and purchase the crrect qualifying substitutin securities fr the prtfli that will generate sufficient cashflw t meet the payment bligatins under the lan until maturity, and deliver the securities t the securities intermediary. The securities intermediary serves as custdian f the securities, and will be respnsible fr making mnthly payments in cnnectin with the lan frm prceeds f the securities. The brrwer purchases the securities and pledges these in favur f the lender in exchange fr releasing the security ver the real prperty securing the lan. The securities will be held by the securities intermediary in a segregated accunt in the name f the brrwer, fr the benefit f the lender. Simultaneusly, the brrwer assigns the lan and the substitutin securities t a successr brrwer, typically a newly created inslvency remte special purpse vehicle, which assumes all f the bligatins and liabilities f the existing brrwer under the lan and defeasance dcuments. Once transferred t the successr brrwer, the riginal brrwer is released frm its bligatins under the lan. The defeasance prcess typically takes 30 days t cmplete (a 30-day minimum ntice perid is typical), althugh timing will depend n the cmplexity and deal vlume f each transactin. In certain circumstances, apprval frm the rating agencies will be required t ensure that the substitutin f the securities will nt result in a dwngrade f the existing securities. Tax advice is als required t ensure that the defeasance transactin des nt breach any US Real Estate Mrtgage Investment Cnduit (REMIC) rules. What dcumentatin is invlved? The key dcumentatin in a defeasance transactin are: Defeasance accunt agreement This agreement cntains the instructin t the lender t hld the securities in a pledged accunt and gverns the manner in which the accunt is t be perated and managed by the securities intermediary thrughut the remaining life f the lan. Defeasance pledge and security agreement This agreement grants the lender a security interest in the securities (alng with certain ther cllateral and the prceeds theref) t secure the payment and perfrmance f amunts payable under the lan dcuments. The trustee can then release the mrtgage ver the real prperty as the securities are substituted as cllateral in place f the real prperty. Defeasance assignment, assumptin and release agreement This agreement dcuments the assignment by the brrwer and the assumptin by the successr brrwer f certain f the brrwer's rights, duties and bligatins under the lan and ther defeasance dcuments.

3 Page 3 The brrwer will want t ensure that the allcatin f liability fr any shrtfall mves frm the brrwer t the successr brrwer, and all representatins (subject t certain exceptins such as fraud and misrepresentatin) are transferred frm the brrwer t the successr brrwer. The brrwer als assigns its interest in the securities that have been pledged as cllateral under the pledge agreement t the successr brrwer. Certificate f brrwer Prvided by the brrwer t cnfirm that all cnditins t the defeasance prcess have been met. Mdificatin, waiver and cnsent agreement Under this agreement the trustee will waive certain requirements under the lan dcuments fr the defeasance f the lan that cannt be met (eg waiving the requirement fr a rating agency cnfirmatin) Legal pinin This is typically given in relatin t the REMIC trust t cnfirm that the defeasance f the mrtgage lan will nt affect the status f the related REMIC. Additinally, a perfectin and enfrceability pinin will als be prepared t cnfirm a perfected security interest in the securities. Rating agency cnfirmatin A cnfirmatin that the defeasance prcess will nt adversely affect the current rating f the securities may be required. In 'new-nte style' r 'New Yrk style' defeasance transactins, the prcess is structured as an assignment rather than a release f the security, in rder t avid the payment f certain mrtgage recrding taxes. Fr these transactins, the fllwing additinal dcumentatin will be required: a defeasance nte, which will be given by the brrwer t the refinancing lender (the new lender) Lender assignment, assumptin and release agreement Under this agreement the lender transfers the lan and the mrtgage n the real prperty t the new lender in exchange fr the defeasance nte and the assumptin f the new lender's bligatins under the defeasance dcuments. What are the advantages f defeasance? The prperty is released frm the existing charge and the brrwer released frm all its bligatins and liabilities in cnnectin with the lan. In certain cases, it is pssible t defease the lan with securities csting less than utstanding principal balance f the lan (ie where the prevailing interest rate f the gvernment securities is higher than the interest rate f the existing lan). If negtiated at the time f lan riginatin, it is pssible fr the brrwer t share in the residual value if there is accrued interest n the securities frm the date f maturity until the date f payment f the relevant securities, r any residual value at the end f the lan term. What are the disadvantages f defeasance? Defeasance ffers an attractive ptin fr brrwers, but difficulties may arise: if the underlying gvernment securities are subsequently dwngraded frm a required rating agency rating (if applicable), r if the relevant securitised debt transactin is nly partially defeased (eg the cllateral is a cmbinatin f gvernment securities and cmmercial real estate mrtgages), the defeasance

4 Page 4 f a securitised lan can ptentially negatively impact n the rating f the pl in which it is securitised There are certain circumstances where defeasance may nt be the mst apprpriate ptin, fr example: if the mrtgage lan is crss cllaterised with anther mrtgage lan and: the lan and/r the mrtgage des nt allw the severing f the crss cllateralisatin upn defeasance f the mrtgage lan, r where defeasance f bth mrtgage lans t sever the crss cllateralisatin is required, r where the criteria under the REMIC rules are nt met In these cases, yield maintenance, as an alternative t defeasance, may be a mre attractive t brrwers. What is yield maintenance? As with the cncept f defeasance, yield maintenance is prevalent in the US and is an alternative t the typical 'declining balance' frmula fr prepayment fees. As with defeasance, yield maintenance similarly seeks t ensure that any prepayment fee des nt adversely impact the anticipated return t investrs n the initial investment. Hwever, yield maintenance differs frm defeasance in that it des nt invlve the substitutin f alternative securities fr the underlying cllateral, but is the actual prepayment f a lan using a predefined frmula in the fixed rate lan agreement which is calculated using the current bnd market yields t discunt the remaining lan payments in the term. Typically the yield maintenance payment cnsists f the unpaid principal balance f the lan and a prepayment penalty. The prepayment penalty is determined by calculating the replacement rate, which is the current yield n the relevant substitute svereign securities that matures clsest t the maturity date f the lan. The difference between the rate n the underlying lan and the yield rate f the relevant securities will be the replacement rate. Yield maintenance prvisins usually incrprate a minimum payment f between 1% and 3% f the utstanding principal balance f the lan. This effectively puts a flr amunt n the yield maintenance that the lender will receive. What are the advantages f yield maintenance? Additinal upfrnt csts invlved are significantly less than with defeasance, as there are n additinal parties t negtiate with, and n additinal dcuments t enter int. With n additinal cnsent and ntice requirements (ther than thse specified in the lan dcuments), the prcess is much simpler ffering a quicker exit ptin t brrwers. What are the disadvantages f yield maintenance? While upfrnt csts are reduced cmpared with defeasance, the verall csts can be greater as there is n pprtunity t share in the residual value f the substituted securities. The lan is prepaid, but n substitutin f cllateral r assignment f the debt ccurs. Due t the difficulty in mdifying lans nce riginated, brrwers shuld ensure that favurable terms are negtiated at riginatin in relatin t bth defeasance and yield maintenance and included in the lan dcumentatin (including, in relatin t defeasance nly, the ability t appint a successr brrwer). Hw has defeasance and yield maintenance been develping in Eurpe? Bth defeasance and yield maintenance are attractive t investrs and brrwers alike. Fr investrs, the risk that the return n investment will be far lwer than riginally anticipated is greatly reduced. In relatin t defeasance, the additinal benefit t the lender is that the credit quality f the underlying cllateral is actually

5 Page 5 enhanced, as the real estate is replaced with high grade svereign securities. Fr brrwers, each ptin ffers the flexibility f an early exit rute fr a defined cst. In Eurpe, the cncepts f defeasance and yield maintenance are nt currently rutinely seen in lan dcumentatin and an advanced defeasance industry similar t that in existence in the US des nt exist. Hwever, given the prepnderance t prepayment in the Eurpean market in the past, and the fact that the Eurpean cmmercial real estate market is seeing a number f US entrants familiar with the cncept f defeasance and yield maintenance prvisins emerge, there will likely be an increasing expectatin that Eurpean cmmercial real estate transactins will ffer the same ptins t enable prepayment cmbined with a maintenance f the expected returns t investrs in a refinancing r prperty sale situatin. This has been seen t a limited extent with sme US insurance cmpanies intrducing the cncept f yield maintenance int Eurpean lan dcumentatin in recent transactins and brrwers requesting the ptin t have flexibility t defease thrugh substituting security. Any final thughts? The practice f defeasance and yield maintenance are well knwn in the US and a specialist industry has develped arund these cncepts. Related prvisins in lan dcumentatin are cmmnplace in US lans, and the chsen prepayment rute identified and negtiated at lan riginatin. Defeasance and yield maintenance ffer their wn distinct benefits and disadvantages t brrwers, and the chsen prepayment mechanism will be largely dependent n a number f factrs, including the cmmercial ratinale fr the transactin, and als market cnditins at the time f riginatin and the predicted future yields f the substitute securities. With an increase in US entrants int the Eurpean market, there will be an appetite fr yield maintenance and defeasance in lan dcumentatin, which is already being reflected in the pricing structures currently being ffered by US investrs, and it is likely that the Eurpean markets will cntinue t witness a grwth in such cncepts. The views expressed by ur Legal Analysis interviewees are nt necessarily thse f the prprietr.