FEATURE ARTICLE, DECEMBER 2007

A DECISIVE DISPOSITION SAVES TIME AND MONEY
It pays to know the impact of defeasance on the property sales process.
Betsy Ross

Ross

Approximately half of the 2,700 defeasances that will be completed this year will result because of a property sale. Sellers who understand the timing of a defeasance transaction can ensure that their defeasance does not delay the closing of the property sale. It’s important to know about the timing of a defeasance transaction. Also, by adding certain provisions to the sales contract, sellers can reduce the risk that the defeasance costs them money if the buyer fails to close the purchase of the property.

Defeasance & Closing Timing

A defeasance typically takes 30 days to complete, beginning with the borrower’s notification to the lender of his intention to defease the loan. If the loan balance exceeds $20 million, the rating agencies that monitor CMBS bond issuances will review the structure of the transaction. This review process takes 2 weeks, and these larger transactions almost always require the full 30 days to complete. For smaller loans (less than $20 million), the process can sometimes be completed more quickly, but it is prudent to allow 30 days.

A defeasance closing has timing issues that impact the sale transaction. A defeasance closing typically takes 3 days. The defeasance will close in the same escrow as the real estate property sale, and the buyer’s funds (and/or its lender’s funds) will be used to purchase the substitute securities portfolio. On the first day of the 3-day closing, the seller purchases the securities portfolio for settlement (payment) 2 days later. On the second day, both buyer and seller make all of their deliveries into escrow, including the purchase price to be provided by the buyer and its lender. On the third day, the securities are delivered, the securities dealer is paid and the defeasance is subsequently closed. The real estate sales transaction can then close because the existing mortgage has been discharged. It is important to set the buyer’s expectations about the closing through the sales contract as discussed below.

Starting the Process

Ideally, sellers should notify their lenders 30 days prior to the scheduled sale closing date. This will ensure that the defeasance occurs simultaneously with the sale, which is all completed in the same escrow. In today’s hot real estate market, many transactions include short due diligence periods before the buyer’s deposit becomes non-refundable, and the closing takes place very quickly thereafter. The defeasance can be managed to coincide with this timing as long as the buyer and seller agree on it up front.

The Seller’s Risk

Sellers are often concerned about the consequences if their buyer fails to close, and they have already notified the lender of the defeasance. The good news is that if the sale closing is simply delayed, the defeasance will be put on hold until the buyer and seller are ready to close. If the property fails to sell at all, however, the seller will have to pay the servicer’s processing fee, as well as the servicer’s legal fees incurred to date. The amount the seller will pay out of pocket varies with loan size, ranging from $25,000 for loans under $10 million to $75,000 for very large loans.

Defeasance and the Sale Contract

Sellers can reduce the risk of out-of-pocket costs on a defeasance by adding some simple language to the sales contract. There are several provisions that sellers should consider:

• Closing Date Timing: The most conservative approach to setting a closing date is to provide for a 30-day closing period after the buyer’s deposit becomes non-refundable under the sale contract. With this approach, the seller can be sure the buyer will close before notifying the lender of the defeasance. If the sale fails to close, the seller can use the buyer’s deposit to cover any out-of-pocket costs on the defeasance. Some sellers also add an extension option in case the defeasance documentation is not completed in time for the closing, but this is typically not necessary.

• Release of Deposit: If a 30-day closing period is not feasible, the contract can alternatively provide that a portion of the initial refundable deposit become non-refundable once the seller notifies the lender of the defeasance. As stated above, $100,000 or less is typically sufficient to cover any costs to the seller.

• Deliveries Into Closing: The sales contract should state that both buyer and seller will make all of their deliveries into closing at least 1 day prior to the closing date. Then, when the securities are delivered on the closing day (the third day of the 3-day defeasance closing period), the buyer’s funds can be used to pay for the securities. Buyers and their lenders sometimes resist this provision, but the mechanics of the transaction are such that it is very difficult to get all of the wires delivered properly if the purchase funds are not provided a day in advance of the closing. If the wires are not delivered in time, the defeasance and/or the real estate closing may be delayed. Lenders will receive gap coverage from the title company, and the buyer will be entitled to receive any interest that accrues on the purchase funds overnight.

• General Defeasance Provision: It is also prudent to include in the contract a provision stating basic information about the existing loan and recognizing the seller’s intention to defease the loan. This provision should include a requirement that the buyer cooperate with the reasonable and customary requirements of the defeasance, including the delivery of the funds and documents into escrow at least 1 day in advance of the closing.

Betsy Ross is a principal at Capital Defeasance Group.

©2007 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.