The defeasance process: real estate finance tool: prepaying a loan without actually prepaying.

A form of commercial real estate finance commonly used over the past decade has been the securitized mortgage loan, otherwise known as the "conduit loan."

These loans are popular because the interest rates are much lower than traditional bank loans and the lender's recourse is limited to the real estate collateral itself. Once the loan is made, the lender assigns the loan (together with a pool of similar loans) to a specially created trust which qualifies as a "real estate mortgage investment conduit" under the Internal Revenue Code, which in turn issues commercial mortgage pass-through certificates to investors.

The holders of these certificates are investing as bondholders not as active real estate investors. They want to clip coupons. The last thing these investors want is for the underlying real estate loans to be prepaid. As a result, conduit loans typically have a prohibition against prepayment.

This prohibition on prepayment becomes a problem for sellers when the prospective buyer of appreciated real property is dependent upon new financing. Conduit loans require the borrower to be a bankruptcy remote, single/special purpose entity whose only asset is the real estate being financed and whose only creditor is the real estate lender. The increased value of the real property requires the buyer to obtain a loan greater than the amount of the original conduit loan, but the terms of the existing conduit loan prohibit prepayment and prevent the buyer from placing a "second deed of trust" on the real property. To facilitate such a sale or refinancing of real property subject to a conduit loan, lenders have created the defeasance process.

Defeasance is the substitution of government securities as collateral for the conduit loan. Unlike a payoff, in a defeasance the original loan is not paid off, but the deed of trust securing the loan is reconveyed. The original borrower purchases government securities (usually using the proceeds from a sale or refinance to do so), in such amounts and with such maturities as to be sufficient to make all debt service payments for the remaining term of the loan, including the final payment at maturity.

Immediately thereafter, the original borrower pledges such government securities to the existing lender as substitute collateral for the loan. Next, the original borrower assigns and transfers the government securities to a newly created, special purpose entity commonly known as the "successor borrower" in exchange for: (1.) the successor borrower assuming all of the obligations of the original borrower under the existing promissory note, (2.) the lender reconveying the deed of trust on the original borrower's real estate, and (3.) the lender releasing the original borrower from any further liability arising under the existing loan.

A number of professionals are needed to complete the defeasance process. An accounting firm must be involved to verify and issue an opinion that the purchased securities will produce a payment stream sufficient to cover the debt ser vice. Securities dealers are needed to acquire the government securities. A securities intermediary is needed to hold the securities, in book-entry form, in the name of the successor borrower. Attorneys are needed to draft the significant amount of documentation involved in a defeasance (including a Pledge and Security Agreement, Defeasance Account Agreement, and a Defeasance Assignment, Assumption and Release Agreement), and to carefully coordinate the closing of the defeasance process.

Depending upon the size of the transaction, rating agencies may become involved. Defeasance companies guide borrowers through this process, and the large investment banking houses often have their own defeasance departments to facilitate the defeasance of conduit loans which they are either holding or servicing.

The cost to the original borrower for such a defeasance varies depending upon market interest rates. Because government securities trade at different prices on a daily basis, the exact cost of the government securities needed to complete a defeasance will not be known until the securities are "circled" or purchased three days prior to the close of the defeasance. Until then, only an estimate of the cost is provided to the original borrower. Nevertheless, despite the large number of parties involved in a defeasance, and the unknown exact cost to the original borrower until right before closing, defeasance has proven itself to be a commonly-used and useful tool for borrowers and lenders to facilitate the sale or refinancing of otherwise restricted properties.

Keith T. Zimmet is the Managing Shareholder of Lewitt, Hackman, Shapiro, Marshall & Harlan, and Chairs the Firm's Commercial Law Department.